Introductionto Business

Business Management Study Manuals

Certificate in Business Management INTRODUCTIONTO BUSINESS

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INTRODUCTION TO BUSINESS

Contents

Unit Title Page

1 Nature and Purpose of Business Activities 1 Introduction 2 The Economic Context of Business 2 The UK Economy 9 Population and the Labour Force 12 The Public and Private Sectors of the Economy 14

2 Structures of Business 19 Introduction 20 Basic Forms of Business Organisations 20 The Sole Trader 21 Partnerships 23 Companies 25 Public Sector Organisations 30 Not-For-Profit Organisations 33 Objectives of Organisations 34

3 Structures of Organisations 37 Introduction 38 Formal and Informal Structures 39 Infrastructure 39 The Functional Departments of a Business 43

4 Organisations in their Environment 47 Introduction 48 Analysing the Environment 48 Stakeholders 52 Responding to Change in the Environment 56 Services to Business 59 Location of Industry 62

5 Growth and Scale of Business Organisations 69 Introduction 70 Growth Strategies 71 How Do Organisations Grow? 73 Economies of Scale 77 Diseconomies of Scale 79 Globalisation 81 Unit Title Page

6 The Production Function 87 Introduction 88 Production Systems and Techniques 89 Control 92 Stocks 97 Quality 101

7 The Marketing Function 109 Introduction 111 The Nature of Marketing 112 Market Analysis and Research 116 Marketing Plans 122 Customers and Markets 123 The Product 127 Pricing 132 Promotion 134 Distribution 137 The Marketing Mix and the Product Life Cycle 138

8 The Finance and Accounting Function 141 Introduction 143 The Basics of Business Finance 144 Sources of Finance 146 The Finance Providers 151 The Structure of an Organisation's Finance 152 The Accounting Function 159 Financial Accounts 162

9 The Human Resources Function 171 Introduction 173 Concept and Scope of Human Resource Management 174 Human Resource Planning 176 Recruitment and Selection 182 Training and Development 189 Motivation 194 Remuneration 199 1

Study Unit 1 Nature and Purpose of Business Activities

Contents Page

Introduction 2

A. The Economic Context of Business 2 What Is Economics? 2 What Are Resources? 3 The Scarcity of Resources 4 Types of Economy 5 Some Features of Markets 8

B. The UK Economy 9 Classifying Productive Enterprise 9 UK Industry 10 Resources 11 Foreign Investment 11

C. Population and the Labour Force 12 The Ageing Population of the UK 12 Optimum Population 12 The UK Labour Force 13 Productivity 13

D. The Public and Private Sectors of the Economy 14 The Public Sector 14 The Private Sector 15 Ownership and Control 16 Accountability 17 Stakeholders 17

INTRODUCTION

Business takes place within an economic structure. How the economy operates dictates how business in general functions and how individual business organisations work. The legal, political and social systems within which such organisations exist are geared to the requirements of a particular type of economy and the economic structure reflects the expectations of the political and social spheres. They are all inter-related and influence each other. Modern economies have the same basic industrial divisions. How much of the economy is devoted to agriculture, industry and services depends on the stage of economic development, political decisions and pressures, and the relative success of enterprises in the sectors. The population structure is important to organisations. For businesses it provides the labour force and the market for consumer goods and services. Other organisations are also vitally concerned with the make-up of the population. Local government has to provide the services appropriate to the local populace. The age structure of the population determines the present and future labour force. The size of the working population depends on social factors, like married women working, and on government decisions on the school leaving age and the payment of pensions. One of the key divisions within the economy is that between the private and public sectors. We consider the issues involved in government intervention in economic activities, ownership and control and the accountability to the various stakeholders. Objectives When you have completed this study unit you will be able to:  Describe the inputs required by business and how markets operate.  Describe the industrial sectors in a modern economy and outline recent changes in the British economy.  Show the relationship between total population and the labour force and explain the effects of changes in the population on the labour force.  Distinguish between the private and public sectors of the economy.  Explain how different organisations are owned and controlled with reference to their stakeholders.

A. THE ECONOMIC CONTEXT OF BUSINESS

What Is Economics? We shall start by carrying out a little experiment. Make a list of all the things you need or would like to have. Don't hold back on this – put everything down. It doesn't matter at this stage whether you can afford them or not. Your list might start like this – food, shelter, clothing, transport, leisure, and so on. However, you can extend and refine this by going into detail, such as a BMW car (or even his and hers BMWs). It should quickly become clear that your list (in common with that of most people) is very extensive. Now think about the total weekly or monthly income that you have in the way of wages, salary or other income to buy items from your wanted list. It doesn't take long to realise that your income is nowhere near large enough to enable you to buy all, or even most, of the

© ABE and RRC Nature and Purpose of Business Activities 3 items on your list. This would still be true if you looked at your income over a year or even a lifetime. What is true for you is also true for virtually everyone else. The fact that we do not have enough income to buy ourselves a villa in the south of France, a yacht in the Bahamas or even one BMW will scarcely come as a surprise. The question is why? The most obvious answer is that we don't earn enough, so one solution might be to simply double everyone's income. However, if we think that through, we can see that it is not really the answer at all. With twice the money, you might actually be able to afford a BMW, but so will a lot of other people. The problem then is that there are not enough BMWs for everyone to buy. Without going into a lot of theory, the likely result of this flood of increased purchasing power into the economic system would be to push up the prices of all the things we want, meaning that our increased incomes would not buy us anything more than the lower level of income that we had before. So, the underlying problem of being not able to have everything we want is not lack of income itself. This merely seems to reflect something more fundamental – it would appear that it is the scarcity of the goods and services themselves which is the problem. But is it? If we look at our economic system, we can see that what we want from it is a stream of outputs of goods and services in order to satisfy our wants. However, we don't get these outputs from nowhere. In order to have outputs, we have to have some inputs which can be transformed into those outputs. In economics, the inputs required to produce outputs in the form of goods and services are called economic resources (or sometimes factors of production). The ability to supply the goods and services that we want is dependent, therefore, upon the supply of the resources required to produce them. (In advanced economies, the transformation of the inputs of resources into outputs of goods and services is usually done by business organisations.) Perhaps we can now see the real reason why we cannot have all the items on our list – the economy simply does not have enough resources to make all the outputs of goods and services we want from it. This gives us a definition of economics. It is concerned with how limited resources are used to produce outputs of goods and services. However, "use" can be an ambiguous term – economists are not concerned with the way in which metal and rubber are transformed in a factory to make a BMW. They are, rather, concerned with the availability of metal and rubber, and why those scarce resources are used to produce a BMW as opposed to, say, a bus. In other words, economics is concerned with the way those resources are allocated between alternative uses – how limited resources are allocated in the production of goods and services. This is not our concern here – economics will be studied elsewhere in your course. We are interested in the way in which businesses transform resources into goods and services – the principles behind the way in which, for example, metal and rubber are transformed in a factory to make a BMW. However, these basic economic principles provide the framework within which businesses operate and we need to understand them in a little more detail before we can come to a view as to what constitutes business.

What Are Resources? Resources can be divided into three categories:  labour;  capital; and  natural resources.

(a) Labour Every economy has a workforce – i.e. the total number of people who are available to work, for gain, to produce goods and services. In the UK at present, this is approaching 28 million people. Another aspect of the supply of labour is the hours which workers are available to work. Some workers would be available full–time, while others would only be available on a part–time or temporary basis. (And, similarly, the jobs which workers do may be full– time, part–time or temporary, although not necessarily in accordance with the desired availability of the workers themselves.) We could arrive at a more precise figure of the available labour force by looking at person hours – i.e. the number in the workforce multiplied by hours available. A further aspect of the supply of labour is the skills of the workforce. In order to produce particular goods and services, we invariably need resources with particular characteristics – not just any old resource. Labour is just the same. The skills available within the workforce can be a significant factor in the goods and services the economy can produce. (b) Capital Capital refers to all those manufactured assets which exist to help in the production of goods and services. Capital assets include:  buildings – factories, offices, etc.;  plant, machinery and tools;  office equipment;  roads, railways and airports;  docks and harbours. All economies have a stock of capital assets which have been accumulated over time. (c) Natural resources This includes anything which comes from planet Earth and can be used as a resource. It includes unimproved land, minerals (oil, coal, etc.), water and so on. We can say that, in theory, natural resources cost us nothing to make (unlike capital). However, there will usually be some cost incurred in exploiting them – land may have to be drained or irrigated, minerals have to be mined or water put into reservoirs, etc.

The Scarcity of Resources At any point in time, the economy will have a limited number of resources available to produce outputs:  a given workforce with a given skill level;  a certain stock of capital assets;  given natural resources. It follows that, even if the economy was able to use all of its available resources, it would be capable of producing only a limited amount of output. In this sense, then, resources are scarce. Scarce simply means limited in relation to our wants. It is the fundamental reason why we cannot have all we want. However, can anything be done to increase resources? The answer is "yes", up to a point. Let us examine this in detail for each type of resource.

(a) Increasing the supply of labour The options for achieving this include:  to increase the population which, over time, should produce a larger workforce;  to persuade more people to join the workforce, for example by raising the retirement age or reducing the school leaving age (to, say 11!) or by other devices;  to improve the skill level of the workforce (which will not increase the size of the workforce, but should improve its performance). (b) Increasing the supply of capital As we use capital assets in the production of goods and services, they are bound to wear out. For example, a lorry is going to wear out as it is used to transport goods to shops. This wearing out process is known as depreciation. If nothing was done about depreciation, the capital stock would get smaller and that, in turn, would reduce the amount of output that could be produced. It is clear, therefore, that the economy must take action to ensure that its capital stock does not shrink, and also, wherever possible, to try to make it larger. The activity of creating new capital stock is called investment. Investment is defined as spending on capital assets. What we are saying, then, is that in order to maintain capital and, thereby, maintain output, there has to be enough investment and for that to happen we have to postpone some present consumption to release resources for investment. (c) Increasing the supply of natural resources You will have noticed that with capital and labour, a quality dimension can exist: with labour, it could be the skill level; with capital, the better performance of newer units of equipment. The same can apply to natural resources. Natural resources essentially cost us nothing to produce – land, minerals, water, etc. are just there. There is, though, a cost involved in extracting/collecting and storing them before they can be used. However, even then they may not be usable in their natural state. For example, oil needs to be refined – into, say, petrol – before it can be used. It is possible, therefore, to change the characteristics of natural resources, or improve their quality, to make them more useful in production. But can natural resources be increased? The answer must be "no". However, it is worse that that. The available amounts of land or water in the world stay much the same although, in the case of land, degradation (i.e. a loss of quality) may well occur. Mineral resources, however, are depleted over time. We assume that the world has a given amount of minerals and fossil fuels and, as they are exploited, the remaining stocks will fall. This situation generates considerable debate about our use of these "non–renewable" resources – an issue which will crop up again later in the course. Overall then, we can see that, as far as resources are concerned, it should be possible to increase the available amounts of labour and capital, but there are problems with natural resources, especially the non–renewable variety.

Types of Economy We have seen that all economies are faced with the central problem that although wants are virtually unlimited, the means of satisfying them are not. As a result, choices have to be

© ABE and RRC 6 Nature and Purpose of Business Activities made – essentially about how scarce resources are allocated in the production of goods and services. There are three main questions to consider in respect of this:  who chooses?  how do they choose?  how are the goods and services which are produced, shared out? In most modern economies these decisions are made by a combination of state provision and free market provision. (a) Market economies An economy without government intervention is known as a market economy. This is a market based on individuals making their own choices about resource allocation. So how does it work? The following diagram outlines the basics of the market system.

Firms

B C

End product Resource markets markets

A D

Households

There are two main types of market:  end product markets; and  resource markets. Households contain consumers. Consumers are free to express their wants by demanding (i.e. being prepared to buy) goods and services in end product markets. They will want to buy those goods and services which they think will best satisfy their wants. This demand is represented by the arrow A in the diagram. Firms (producers) respond by producing and supplying to the markets those goods and services which consumers want to buy. This is represented by B in the diagram. The motive of the firms is gain – they expect to make profits from selling goods and services. In order to produce those goods, firms have to buy or hire the resources to make them. These resources will be in the form of labour, capital and natural resources. Since these resources are scarce, firms compete with each other to get the resources they need. As a result, the owners of those resources will be able to command payments. We are now in a different set of markets – resource or factor markets. These are represented on the right of the diagram. In a market economy, the ownership of resources is vested in households. This may seem strange at first. We can appreciate that households will own labour, but surely capital, as we have defined it, and natural resources are owned by organisations, not individual households?

If we think about this further, though, we realise that organisations themselves are owned. For example, if we take a limited company which operates plant and machinery, or a mining company which exploits mineral reserves – who owns these firms? Firms are, naturally enough, owned by their owners. Their owners may be individuals or partners, or in the case of public and private limited companies, shareholders. These are all individuals – i.e. members of households. It is, therefore, not the company which owns the plant, machinery or minerals, it is the members of households who own the company. (You can see this by looking at any set of company accounts.) So, households own the economy's resources. They are prepared to offer them to firms in return for incomes in the form of wages/salaries, dividends, interest payments, rents, etc. There are a range of resource markets in which firms are demanding resources and households are supplying them. For example, if you are employed, you are involved in one of these resource markets – the labour market – where you are selling your time and skills to an employer (a firm) in return for an income. The demand for resources from the firms sector is shown by the arrow C and the supply of resources from the households sector is shown by the arrow D. If you are employed, you will be well aware that you are a resource owner, selling that resource (labour) for what you can get, and then using the resulting income to finance your demand for goods and services. However, you will also be aware that the ownership of resources is by no means even and that not all resources command the same prices. The result of this is that incomes are very uneven and it is income which gives us command over the goods and services we need. In a market economy, distribution is determined by income. This brief outline of the market economy shows clearly that decisions about resource allocation lie with individuals, not the state. Ultimately, consumers have the final say in what will and will not be produced. Firms only produce those goods and services that consumers will buy. And firms will then only buy/hire resources to produce those goods and services that consumers want to buy. This is what is referred to as consumer sovereignty. (b) Mixed economies No country has a pure market economy. To varying degrees all economies are "mixed", i.e. they are a combination of state provision and free markets. The UK is a mixed economy, as is the case with most other economies. This means that certain goods and services are provided by the state and, in order to do this, the state must take control over certain aspects of resource allocation and distribution in the same way as in a command economy. The state can be central and/or local government, and the aspects of the economy in which it is involved are known as the public sector. By contrast, the market aspects of the economy are known as the private sector. The actual mix varies between different economies from large public sector/small private sector to small public sector/large private sector. In many economies the boundary between the two sectors is shifting. It may happen that services provided by the state sector are "privatised" and put into the market sector, or the move may be in the opposite direction, for example by "nationalisation" where the state takes over from the market. In the UK, as in many countries in recent years, there has been a trend toward reducing the state's role and expanding the market's role. We shall consider the issue of public and private sector activity in a mixed economy later in this unit.

Some Features of Markets The word "market" has already cropped up and we have identified a few basic features. We now need to define the term properly and examine in some detail how a market operates. So, what is a market? A market is an organised situation which enables buyers and sellers to be in contact for the purpose of exchange. There are a number of key features of markets which are implied by this definition.  A market does not have to be an actual place. Sometimes it is – for example, a street market or a car boot sale – but it will often be a communications system. Examples include the stock market (the market for securities) or the foreign exchange market (where currencies are bought and sold). We often speak of the "labour market", although there is no such place (nowadays) as a market place for labour. The only thing that matters is that buyers and sellers can do business.  There will be two sides to any market – buyers and sellers. These roles are usually held by different people, but sometimes people switch roles. For example, in the stock market, someone may be a buyer today, but a seller tomorrow (but in most markets, such role changes are unusual).  Something of value is being exchanged. This might be a service or a good. In most markets, goods and services are exchanged for money. In markets where goods are exchanged for other goods directly the system of exchange is called barter. In most of the developed world, barter is rare, but it does still happen – tankers of oil have been exchanged for cargoes of wood on a barter basis, and you only have to go into any school playground at break time to appreciate that barter is alive and well.  If goods/services are being exchanged for money then a rate of exchange has to be worked out – how much money should be exchanged for a unit of the good? This rate of exchange is called price. A central function of a market is to determine the price. To be effective, markets must allow all these things to happen. In most developed economies, the market system is predominant. The "market economy" describes an economic system where goods and services are exchanged for money through markets, although a "pure" market economy in which all goods and services are exchanged in markets does not exist. You can imagine that the market economy will consist of a network of many thousands of individual markets which will all be inter-related in different ways. We can try to make some sense of this mass of markets by classifying them into a system. We have already made a start on this in the diagram in the previous section. We shall now develop this. We can identify four main groups of market:  end product;  resource;  intermediate; and  financial. These may be defined as follows:

(a) End product markets As the name implies, these are markets in which finished goods and services are traded. "Finished" means that the buyers do not intend to process them further or sell them on. Most of these markets will be for consumer goods and services and will include all those retail markets with which we are familiar. (b) Resource markets Resource markets are where the basic economic resources of labour, natural resources and capital goods are traded. (c) Intermediate markets Intermediate markets are those for part-finished or semi-finished goods. These include components or parts made by one firm for another. Because of the nature of the goods changing hands, you will appreciate that these markets are dominated by firms – they are inter-firm markets. So, for example, if a motor manufacturer buys glass parts for car windows from an outside supplier, then the manufacturer and the supplier are involved in an intermediate market. (d) Financial markets Money is needed by firms and households to fund various types of economic activities. If they do not have access to the necessary funds at the time they need them, they may be able to get them through the financial markets. Financial markets are those in which funds are traded. There are a wide range of these markets in which various types of funds are traded – for example, there are markets for very short-term funds (where money is needed for short periods, such as overnight or for a few days or weeks), long-term markets where firms can obtain funds to finance capital expenditure, and the foreign exchange market where the £ is traded against other currencies. In a market economy, because of consumer sovereignty, we could argue that what is happening in the resource, intermediate and financial markets reflects what is happening in the end product markets. If, say, consumer demand for cars rises, car firms will want to increase output. To do this, they will need to employ more resources (for example, workers are asked to work longer hours), seek larger volumes of parts from their suppliers in the intermediate markets (for example, more window glass will be needed), and may need to seek additional funding to finance the increased production in one of the financial markets. To put this another way, the demand level in the resource market, for example, will be derived from the demand in the end product market – the demand for car workers depends upon the demand for cars. When we examine resource, intermediate or financial markets, we have to bear this in mind. We cannot look at these markets in isolation, but must always refer back to the related end product market.

B. THE UK ECONOMY

Classifying Productive Enterprise There are a number of ways in which business enterprises can be classified. (a) Types of industry There are three basic types of industry in which organisations are to be found:  Primary industries – these are the suppliers of raw materials, such as mining, oil extraction, forestry and farming.

 Secondary industries – these are businesses which convert raw materials into goods and services.  Tertiary industries – businesses in this sector are concerned with the distribution of goods to customers, such as transport providers, wholesalers, retail firms, etc. In addition, this sector contains businesses which provide services, such as banks, travel agents and advertising. We now have to recognise that sport has become a major business activity and this should be included within the tertiary sector, although some economists regard sport and leisure as forming a new fourth sector. The growth of tertiary organisations is an important feature of modern society. (b) Labour- and capital-intensive enterprises Some organisations depend heavily on labour to achieve their objectives, while others depend heavily on capital items like machinery or computers. Hence, we can classify organisations as being labour intensive (such as retail shop organisations or the Health Service) or as being capital intensive (such as manufacturing firms which use robots, or enterprises which depend on expensive computers or machines). (c) Product or service enterprises A simple classification is to divide organisations into those which sell a product – such as some tangible object like a car or a TV set – and those which provide a service, such as a bank that allows us a loan. Some organisations combine the two as, for example, the firm which sells us a product and then provides an after-sales service to keep it working properly. (d) Private and public sector organisations Private sector organisations are those which are owned and controlled by individuals or groups of individuals to achieve objectives which they themselves establish. Public sector organisations are those which are owned and controlled by institutions representing the State and responsible to the political machinery of the State, and which are required to pursue objectives established by the political institutions of the State. We shall examine the differences between these organisations later in the unit.

UK Industry As countries develop, the structure of their industries tends to change. The importance of agriculture and then manufacturing falls and services provide a growing proportion of Gross Domestic Product (GDP – the sum of all production in the economy). Thus, there is a movement through the primary, secondary and tertiary sectors in terms of their overall importance to the economy. The share attributable to each sector depends on things like the availability and abundance of resources, history, government policy, and ability to compete in the world market. Britain had the world's first industrial revolution. It would not have been possible without a preceding agricultural revolution which provided the labour force for the new factories and the means to feed them. Long before these events, Britain was a major trading and commercial nation. Over the years there have been changes between the sectors and within them. Employment in agriculture has steadily declined as farming methods have changed. Coal mining is no longer an important industry as its output has been replaced by oil, gas and imports. Technological change played its part with North Sea gas replacing town gas made from coal. The percentage of the labour force employed in service industries has increased at the expense of the primary and secondary sectors.

In 2006 the output of the primary sector accounted for a little over 3% of GDP, the secondary sector for 2% and tertiary industry for 73%.

Resources As we have seen, production requires the transformation of inputs into outputs – the acquisition of economic resources (or factors of production) and their combination and application, through the activities of business enterprises, to produce outputs of goods and services. Britain is well endowed with economic resources, having almost enough oil and gas to cover its needs, although there is considerable trade in oil to get the right mix of grades. The UK is virtually self-sufficient in energy production. Land is not abundant compared to other countries and the UK has about twice the population density per square kilometre compared to the European Union (EU) average. But 77% of the land is used for agriculture and Britain is self-sufficient, or nearly so, in a wide range of foods including wheat, barley, milk, meat, beef, mutton, poultry, eggs and potatoes. The country is well endowed with industrial and social capital such as roads, hospitals and schools. There is a long history of enterprise from before the industrial revolution and many financial institutions and markets have developed to serve it. The London foreign exchange market is the largest in the world and the Stock Exchange the biggest outside the USA. Britain has a growing and educated labour force. The structure of the population and the employment of labour are very important for the performance of the economy, as considered in the next section. The efficiency of labour depends on how well all the factors are combined and utilised in production.

Foreign Investment The structure of industry in Britain has been greatly affected by foreign investment attracted into the country. Many famous names among the merchant banks, like Rothschild, came to London because it was the leading financial centre in the world. Singer, the sewing machine manufacturer, was the first American multinational to set up in the UK, a hundred years ago. Since then there has been a steady stream of firms setting up UK operations or buying into British companies. In more recent times two events have increased overseas investment in the British economy.  North Sea oil and gas attracted many multinationals. Earlier investments were aimed primarily at getting access to the prosperous British market with the opportunity to sell or to set up in neighbouring countries.  When the UK joined the EU it became the favoured location for firms wishing to operate within the Common Market. There are many examples. In the 1960s Britain had several television manufacturers, but foreign competition put them out of business; in the 1990s the UK became an exporter of TVs manufactured in the country but the firms were Japanese owned. Japanese car firms also used England as their entry to the EU. Toyota made the UK its base for European manufacture. This was a Japanese version of the seventy year-old establishment of American car firms – Ford and Vauxhall (General Motors) – in England. Apart from a few small specialists, all of the British car industry is foreign owned. This inward investment creates jobs in the investing firms and in their suppliers; the additional employment means that there is more spending throughout the economy and helps to create, or maintain, jobs in other areas. Dividends and profits are remitted to headquarters abroad, thus affecting the balance of payments. However, exports from foreign-owned firms benefit the trade balance. Investment in assets is known as foreign direct investment; buying stocks and shares is called portfolio investment and does not involve ownership of the company. In the 1980s,

© ABE and RRC 12 Nature and Purpose of Business Activities direct investment in the UK from abroad was about half of the amount invested abroad by British firms. The UK continues to be a net exporter of capital.

C. POPULATION AND THE LABOUR FORCE

The population of the world is over 5 billion people. Between 1950 and 1985 the number of people on the globe doubled. This growth has mainly occurred in the less developed countries (LDCs) as population growth in the industrialised nations has fallen to around or below replacement levels. The main reason for population growth is a decline in death rates; fertility and birth rates remain the same. Growth of the population will continue as so many countries have a majority of their inhabitants in the child-bearing age range. In 1992 half the population of Kenya was below the age of 15. In India it was 37%. As these people start to have families there will be a rapid increase in the population even if every woman has fewer children than was the case during the last twenty years. By the year 2150, Kenya is expected to have a population of 150 million, compared to 18 million in 1982. It is estimated that world population will double by the year 2050. Such rapid change in the population has tremendous implications for the use of resources, availability of workers, the cost of labour and the size and pattern of demand. An expanding young population means more demand for baby products, cots, toys and baby foods, then for education as they grow up and, later, for jobs as they enter the labour market. The economy has to expand very fast to keep up with the demands on it for output and employment. Added pressures come from rising expectations and demands for social welfare and health improvements.

The Ageing Population of the UK Britain has the world's sixteenth largest population at 60.7 million. The age distribution is very different from Kenya, with 17% under age 15 and 16% aged 65 or over. There is 67% in the working age-group of 16 to 65. There are slightly more women (51%) than men (49%). The proportion of elderly people is predicted to rise especially in the over 80s range. This change in the age structure will mean more demand for retirement homes, health care for the aged and leisure pursuits for the elderly. It also poses problems for specific areas of the country. Many of the elderly in the south-east of the UK move to more attractive coastal areas. This shifts the burden of labour-intensive care for the elderly to counties like East Sussex. Demand for public transport and other amenities rises in these retirement areas, yet they are costly to provide to the standards people would like. Change in employment patterns in service industries is imposed. Local market demands alter; the construction industry has to build suitable housing, stores have to offer suitable goods and leisure activities have to cater for golf and bowls instead of soccer and athletics. Pensions and health-care will become a bigger burden on government finances raised through taxes on the smaller employed sector. This is why the government is keen that people should make their own retirement provision and that the age of retirement should be increased, especially for women. As you can see, changes in the age structure of the population have great long-term influences on demand.

Optimum Population The sheer size of the population is not as important as the optimum population. This is the size of working population which gives the greatest output per head with the existing resources. It is a theoretical concept and constantly changes with changes in the other factors and in technology. Its size determines whether or not land and capital will be used

© ABE and RRC Nature and Purpose of Business Activities 13 efficiently. Too large a population can mean too many small, inefficient agricultural holdings and capital going to housing instead of productive investment; too small a population means land remaining unused and resources unexploited. The concept does concentrate attention on the importance of the labour supply.

The UK Labour Force The labour supply depends on the size and age distribution of the population. The school leaving age and the statutory retirement age determine how many are in the working population. Not all of those people may work, however: they may continue to study, retire early or stay at home. The labour force consists of those who are eligible and who offer themselves for work. The supply of labour also depends on the length of the working week and the number of holidays. In 2005 the UK labour force numbered 31,042,000. The distribution of this workforce between the main productive sectors is shown in Table 1.1.

Industrial Sector Employees (Thousands)

Agriculture, forestry, fishing, mining 1.4% 450 Manufacturing and Construction 17.7% 5486 Services and Public Administration 80.9% 25106

Table 1.1: UK Employment by Industry

As well as an increase in employment over the period to 2005, there have been a number of changes in the pattern of employment. A major change is the growth in part-time employment. Almost half of employed women are in part-time jobs; but men, too, are taking more part-time jobs. There is evidence that this is partly a matter of choice and not wholly due to the availability of job offers, as people choose to work part-time rather than full-time. The number of women of working age in jobs has grown. This is due both to more women demanding jobs and the increased availability of suitable employment, especially part-time. The proportion of the self-employed has also grown from 11% to approximately 15% of the labour force. There has also been a change in the type of jobs. The proportion of manual workers has fallen while the number of workers in the service sector has risen. This change is due to changes in technology and the organisation of work. It is also a result of the fact that employment in manufacturing has more than halved since 1979, such a decline being common to all the industrialised economies.

Productivity Even if the size of the population stays the same, output can increase. Social changes bringing more women into jobs, alterations to the rules on retirement and pension rights, different hours of work and more flexibility can all change the labour supply. Even more important effects can result from changes in productivity. Better health and improved education and training bring improvements in output per hour. Changes in the organisation of work, like introducing quality circles and employee empowerment, increase productivity from a more efficient labour force. More investment in capital and the introduction of new technology lead to increased output. Changes in output per head can have dramatic effects on the rate of growth of industries and the economy.

D. THE PUBLIC AND PRIVATE SECTORS OF THE ECONOMY

Organisations are either owned by private sector individuals and groups or they are in the public sector, owned by the nation. There may be little difference in the form of ownership. For example, a public corporation and a private company are in different sectors but have much the same legal structure. The capital of the former, however, is held by the Treasury on behalf of the citizens while that of the latter is held by individuals on their own behalf. There are, though, great differences in objectives and responsibilities. Public sector organisations carry out the tasks assigned to them by Parliament and are responsible to it as represented by the relevant minister of the government. Private companies, on the other hand, exist to make profits by carrying on the activities permitted by their Memoranda, and their managers are responsible to their shareholders. There are also tremendous differences in the size of firms. We shall examine the various types of organisation and their structures in detail in the next study unit. For the moment, we are concerned with the reasons for the existence of the two sectors and with their extent. Over the last fifteen years there has been a revolution in attitudes to public ownership and control. Many public sector organisations have been privatised to gain the benefits of greater efficiency and competition.

The Public Sector Before 1980 a large part of British industry was in the public sector. Around 13% of GDP was produced by nationalised industries responsible for 10% of employment. Some organisations, like the BBC and Bank of England, were taken into public ownership because it was felt that they had a special place in the nation's affairs. Most were nationalised by the post-war Labour government in accordance with the Labour Party's constitution, which called for the public ownership of the more important parts of industrial activity. The nationalised industries were taken into public ownership by setting up public corporations to operate them. Since the Conservative government came to power in 1979, most of these public corporations have been privatised. In addition many economic activities have been deregulated. Banks, building societies and road transport are examples of industries which have had government regulations and controls removed. The role of the public sector as a provider of commercial activities has been greatly reduced. The scope of the public sector has been greatly reduced by privatisation, but it continues to account for over 40% of national expenditure. Much of this is due to government spending on public goods and merit goods such as education, health care, defence, social services and law and order.  Public goods are those which cannot be provided to one individual who pays without non-payers sharing them, like street lighting, or those which have to be provided collectively, like the Navy.  Merit goods are those which society thinks that everyone should have, like basic education and health care. A significant amount of spending of these kinds is controlled by public sector organisations of different types. We will examine the structure and objectives of these organisations in the next study unit. Local government supplies many services to the community including rented housing, leisure facilities, education and road sweeping. Local government operates at a number of levels. In many areas parish councils provide amenity services within their areas. District councils are larger and provide a range of services, including housing and leisure services. County Councils cover a number of District Councils and provide highways, education and

© ABE and RRC Nature and Purpose of Business Activities 15 social services, among others. In some areas, the duties of District and County Councils have been streamlined with new "unitary" authorities. Since 1999, the UK has additionally had a regional level of government, with the election of Scottish and Welsh assemblies. The local council may rent out market stalls, run a theatre and provide conference facilities. Since 1980 local government activities have been increasingly deregulated and contracted out to private firms. However far the privatisation goes, there will always be a role for the public sector. There are activities like the Army, Courts of Justice and the police which have to be provided by the state. Again, some part of these activities may be hived off to private sector organisations, for example the 1994 proposals that the army could lease trucks and the air force could have its planes serviced by private contractors. Even without these activities, the public sector is a major purchaser of goods and services from private firms. Government rules enforcing competitive tendering for public service operations mean that public organisations which want to win the contracts must be as efficient as their competitors in the private sector. Government bodies are required to oversee the activities of private sector organisations. For example the privatised water companies are regulated by Ofwat and the gas industry by Ofgem. There will be a continuing role for central and local government activities which are concerned with the operations of commercial enterprises including the Inspectorates of Health and Safety, Pollution, and Weights and Measures.

The Private Sector The private sector consists of a huge variety of organisations of different kinds. The majority exist to make profits, though there are many which have other aims. Most private sector organisations are small. In manufacturing 94% of enterprises employ fewer than 100 people; two-thirds of firms have fewer than ten employees. Companies employing over 1,000 represented only 0.3% of organisations but accounted for 17% of people in manufacturing enterprises. The picture for charities is similar, with 90% of them sharing only 7.3% of total charity income. In services the vast majority of organisations are sole traders or partnerships. There are many reasons for this, ranging from the ease of setting up a one-person firm to the ability of small enterprises to specialise in providing products and services to localised or "niche" markets. Some industries are dominated by one or a few firms. There are activities like electricity distribution and sewage disposal where a natural monopoly exists. In these cases it does not make sense to most of us that there should be more than one supplier. There would be no advantage from competition. In some activities the technical advantages of large-scale production are so important in reducing costs that only a few firms can serve the market. Similarly there are areas where mass marketing or bulk buying give huge economies and a few large firms dominate the industry. Car production and supermarket retailing are examples. As well as the dominant firms there may be a large number of specialist producers or local suppliers filling the niches which the large companies do not want to serve. In these industries there is a danger that firms will exploit their position to the detriment of consumers and society. The government has to provide a specific regulator, like Ofgem, or approve arrangements for self-regulation, as in the financial services covered by the Personal Investment Authority (PIA) and its specialist industry subsidiaries. A general overview is provided by the Competition Commission, which deals with restrictive trade practices, monopolies and mergers. The general rule is that activities may be investigated if certain conditions apply. A firm which has more than 25% of the market may be examined to see if its activities are contrary to the public interest. If they are, the

Secretary of State for Trade can order it to stop and impose conditions like a maximum price. Mergers can be stopped if the result would be a firm in a dominant position. There are similar EU rules which apply to cases affecting more than one country. These are some of the ways in which public sector organisations may have a direct impact on commercial enterprises in the private sector. The diversity of private organisations and activities reflects the demands of consumers. People get started in business in different ways. A hairdresser may spot an opportunity to provide a home service to the housebound or mothers with young children who do not want to drag them to a salon. In such a field, a minimum of equipment and therefore little capital is required to get started as a sole trader. Others may get the backing of a large organisation by taking a franchise. The franchisee gets the benefit of a business plan, expertise, marketing and technical support and help with finance, in return for a share of the turnover. McDonald's and Kall-Kwik print shops are examples to be found in almost every town. Some businesses can only start large. A steelworks or the Channel Tunnel require very large amounts of capital so they must start as public companies in order to raise money from the widest possible range of sources. Small firms can grow into giants – Marks and Spencer started with a market stall and Trust House Forte with an ice cream parlour. In Study Unit 5 we shall consider how and why firms grow.

Ownership and Control (a) Private sector Legal ownership lies in the hands of the providers of the financial risk capital, also known as the equity. In the private sector there is a fundamental distinction between corporate and non-corporate organisations. A corporate organisation has a separate legal entity and identity of its own that is quite distinct from the identity of the owners, the providers of equity. The most common corporate commercial organisation is the company limited by shares established under the provisions of the Companies Acts and subject to their provisions. Most non-corporate organisations, with the exception of some very large professional service firms in the fields of the law and accountancy, are very small and are completely owned and controlled by one person, the sole proprietor, or by just a few people forming a business partnership. Although there is a duty on the part of all business organisations to keep separate financial accounts for their business activities, there is no legal distinction between the responsibilities and liabilities of the business and the individual proprietors or partners. In the case of the limited company enjoying full corporate status there is a clear division between the responsibilities and liabilities of the company and those of the providers of equity, the ordinary shareholders. One implication of this separation, however, is that the shareholders are not permitted to intervene in the management of the enterprise, the control of which is, therefore, delegated to directors who act on behalf of the shareholders. Directors may appoint a managing director and professional managers to take day-to-day decisions but again have the duty of acting in the interests of shareholders. A shareholder may also be a director and indeed a full- or part-time manager of the enterprise and, of course, many employees are also shareholders under profit-sharing schemes, but the functions of these are separate. (b) Public sector The one feature that is common to all government owned and controlled organisations is that all activities have to be within the powers specifically granted to the organisation by Parliament or under the authority of Parliamentary legislation. As a result the way in which activities are carried out and authorised becomes as important as the activity itself and its results. There can be no possibility of a desirable end justifying means

that might be judged to be beyond the organisation's legal powers. Furthermore, all managers have to be ready to justify their actions in case these are subjected to detailed scrutiny from outside the organisation. This makes administration time- consuming and burdensome and can make managers extremely cautious. In addition, managers are rarely given the freedom of decision-making that is considered normal in an ordinary business company. Some efforts have been made since the mid-1980s to try to improve managerial practices in the public sector, but this has been linked to giving greater financial freedom to institutions such as schools, hospitals and the Post Office. However, for those organisations such as schools and hospitals which rely for their funds on the public purse and whose activities are closely ordered and regulated by State authorities, regulators and inspectors, any attempt to increase managerial independence usually results in increased administration and bureaucracy simply because of the duty imposed on managers to account for the way public money is used and to be able to prove that its use is strictly in accordance with their legal powers. Not only do the above constraints divert scarce resources from productive activities such as classroom teaching and nursing the sick, but they can also create an environment that is hostile to enterprising management and individual initiative.

Accountability (a) Private sector In the main, the private sector firm is accountable to its shareholders. It discharges this responsibility by means of its Annual Report and the Annual General Meeting. Increasingly, the concept of stakeholding, which we discuss below, has meant that firms are now taking account of moral and social responsibilities to their employees and society at large. As part of this, some public companies now publish a social or environmental report in addition to the normal financial reports. (b) Public sector As already explained, public sector organisations are accountable ultimately to Parliament. In principle, government ministers are responsible for general direction and the full-time managers are responsible entirely for day-to-day management. In practice, political decisions may mean that "general direction" dictates many managerial practices and reduces the role of management. One problem for the public sector is that there is little direct accountability between management and Parliament. Government ministers are not generally interested in the detailed operation of the enterprise (nor do they have the time). However, when things go wrong, the implications can be far reaching, not least in political terms.

Stakeholders Many people, apart from the owners and employees, have a stake in organisations, whether private or public sector. Perhaps the most obvious definition of a stakeholder is: anyone with an interest in the business. The importance of the stake depends on the relation to the organisation. Stakeholders can be individuals, groups of people or organisations. The only thing they may have in common is their interest in the business. The interests themselves are not necessarily financial but can encompass social, ethical and moral issues as well. The first task is to identify who the main stakeholders are likely to be. Throughout this analysis we shall be thinking in terms of larger-scale business since these will tend to have the most far-ranging stakeholder interests.

The key stakeholders can be seen as:  Owners, whether sole traders, partners or shareholders, are interested in the financial results of the firm because they have invested their capital and, possibly, their time and effort, and they want to get the maximum return. They must consider their alternatives – whether to stay with the firm or seek better opportunities elsewhere.  Managers and workers want job security, prospects, good working conditions, and pay that recognises their contribution to the success of the business. They look for other features that improve their lives like pension schemes, insurance cover and, in some cases, social and sports facilities provided by the organisation. People expect to receive training. They seek recognition for effort and ideas. Job satisfaction is an important element in peoples' lives.  Customers expect quality products at fair prices, and a high standard of service. Do not forget that commercial customers may depend on suppliers' product quality for the excellence of their own goods and services.  Suppliers look for lasting business relationships and fair treatment. They have an interest in the continuing existence of the organisation as a customer. They may depend on prompt payment to maintain their own cash flow.  The community has a stake in the organisation as an employer. This generates business for other local firms as wages are spent. The organisation may play an important part in local social and community life by providing amenities or through sponsorship.  Government has a direct stake in the public sector organisations which enable it to provide the services promised to the population. National and local government as owners are interested in the financial performance of public enterprises. All sorts of organisations pay taxes which provide national and local government with income to spend on social services, defence, justice and other areas. Thus, governments are very interested in the success or failure of business organisations.  Members of societies, clubs, associations and professions want to receive a satisfactory standard of service. They expect value for their subscriptions and wish to be sure that the organisation is carrying out its objectives.

Study Unit 2 Structures of Business

Contents Page

Introduction 20

A. Basic Forms of Business Organisations 20 Corporate/Non-Corporate Organisations 20 Limited and Unlimited Liability 21

B. The Sole Trader 21 Advantages and Disadvantages 22 Small Limited Companies 22

C. Partnerships 23 Advantages and Disadvantages 24 Large Professional Partnerships 25

D. Companies 25 Private and Public Limited Companies 25 Formation of a Company 26 Finance 26 Structure 27 Advantages and Disadvantages 29

E. Public Sector Organisations 30 Public Corporations 30 Municipal Enterprises 31 Quangos 31 The Public Enterprise and State Ownership Debate 31

F. Not-For-Profit Organisations 33

G. Objectives of Organisations 34

INTRODUCTION

Much of our lives is spent in organisations – at school or college, at work in a firm, and during our leisure time in social or sports clubs or doing religious and voluntary activities. All of it is affected and influenced by the organisations which decide what goods and services are available to us, how much we pay in national and local taxes, what hospital facilities are provided locally, the quality of the water we drink and the television programmes we can watch. There are many types of business organisation to provide for different purposes, scales of operation, needs for finance and the structure preferred by the owners. The main reason for the existence of private sector business organisations is to make a profit, and indeed most private sector businesses aim to maximise profit. Public sector organisations may be expected to make a profit or at least to break even, but their primary objective is usually to provide a service to the public. As we will see later, businesses have a number of objectives which they pursue at the same time but, if they lose sight of the need to make a profit, they risk going out of business or being taken over by more successful concerns. The general organisational, management and leadership principles hold within all commercial organisations, from the small corner shop to the huge multinational. The way in which these principles are applied, however, will vary, given the nature of the organisation's role and/or task. Objectives When you have completed this study unit you will be able to:  Describe the various types of organisation which are found in the private and public sectors.  Discuss the advantages and disadvantages of sole traders, partnerships and companies.  Evaluate the case for the public sector.  Explain how different organisations are owned and controlled with reference to their stakeholders.  Discuss the various objectives of business organisations.

A. BASIC FORMS OF BUSINESS ORGANISATIONS

There are two basic distinctions which underlie the organisation of business enterprise in the private sector.

Corporate/Non-Corporate Organisations Non-corporate organisations are those which do not have a separate legal identity from their owners. This means that the owners are fully liable for the actions of the organisation, including any debts. The main forms of such organisation are:  sole proprietors, still often known as sole traders though they are found in activities other than trade; and  partnerships.

Corporate organisations are those which have a separate legal identity of their own. The most common corporate business organisations are:  public limited companies which can usually be recognised as their official title normally ends with the common abbreviation "plc"; and  private limited companies which can usually be recognised as their official title normally ends with the word "limited" or with the common abbreviation "Ltd". This can sometimes be confusing, however, since many private limited companies are, in fact, subsidiaries of large public limited companies or of foreign companies. Consequently, you may think you are dealing with a small private company, when in reality you are dealing with a minor offshoot of a giant multinational organisation. The legal independence of the limited company, however, can enable the giant to disown its offshoot if it becomes a financial liability.

Limited and Unlimited Liability The term "limited" in public or private limited companies means that the organisation enjoys "limited liability". This exists where the owners of a business have their individual responsibility for its debts limited in some way should it fail. In practical terms this means that the shareholders who are its legal owners are not liable for any debts of the organisation beyond the amount they have paid or agreed to pay for their shares. They may lose all the money they have invested in the company but cannot be called upon to pay any more. The importance of limited liability is that it allows enterprises to raise very large amounts of capital from a great number of investors who need take no part in the running of the business. In contrast to this protection for limited company shareholders, partners and sole traders have unlimited liability for their business debts and may lose everything they own if their business fails. There are a few unlimited companies and a very few limited partnerships but for various reasons these are usually impractical for normal business purposes.

B. THE SOLE TRADER

Also known as the sole proprietor, this is the oldest and simplest form of business enterprise. The proprietor is the sole person who provides the financial resources and who makes the decisions – i.e. he/she both owns and runs the business. There may be employees in the firm, and decision-making may be delegated to some of them, but the final success or failure of the business rests with the proprietor, who provides the funds and takes the profits or the responsibility for any losses. The business is not a legal entity separate from the owner, so the proprietor has unlimited liability and all contracts with the business are made with the individual proprietor, not with the firm. The business is a separate accounting entity which has accounts prepared for it, but these do not need to be a full set of accounts and need only be sufficient to satisfy tax liabilities. In the UK anyone can set up as a sole trader without any formal procedures except where a licence is required to operate, for example to retail wines and spirits or to run a taxicab service. Sole traders exist mainly in small-scale retailing, personal and business services, craft industries, some specialist manufacturing like instrument making and the building of industrial models, and the professions. In some industries, especially building and construction, the sole proprietor business provides services to large firms which may subcontract most of the work on a project to specialists. About 80 per cent of all businesses in Britain are sole traders, but they provide only a very small percentage of total output. They

© ABE and RRC 22 Structures of Business are important to their local communities. They provide an informal and easy way for anyone to start up their own business with a minimum of capital and exploit their specialist skills and knowledge. Being one's own boss is often the main attraction. One feature of the differences between sole traders and companies lies in the ways in which they raise business capital. The sources of finance for the sole trader include the following: the proprietor's own resources; loans from relatives and friends, High Street banks, commercial banks or finance houses; credit from suppliers; government grants (where applicable); and the ploughing back of profits. Note also that the sole proprietor will make use of a wide range of outside services – including solicitors, insurance advisers, bank managers, advertising experts, consultants, employment experts, government agencies, etc.

Advantages and Disadvantages There are a number of benefits from being a sole trader as opposed to any other form of business organisation.  A sole trader business can be established with the minimum of formalities, there are few legal procedures and book-keeping and accounts are straightforward.  The owner has independence and control; there is no need to consult with others about decisions.  The business can respond flexibly to market changes and to customers' demands as decisions can be taken quickly.  Any profit goes to the proprietor.  Personal supervision by the owner should mean that good customer relations can be established and that employees are well motivated. On the other hand, there are disadvantages.  Finance is usually limited to any money the proprietor can provide or borrow from the bank, building society or family and friends; this limits the scale of the business.  Unlimited liability means that, if the business gets into trouble, the owner stands to lose everything, including the family house if it has been put up as security for loans.  Expansion is limited to ploughing back the profits, and lack of finance may prevent the business from reaching a viable size.  The firm depends on the sole proprietor, so there may be problems in taking holidays or if the owner is ill; and the business is likely to cease with the death of the owner.  Any one person's range of expertise is limited; a sole trader may, for instance, be good at repairing the bodywork of damaged cars but completely lacking in financial and marketing skills. Despite the risks many people start up in business every year as sole traders. They are most likely to succeed where there is a specialist niche which they can exploit and where success depends on the personal ability, initiative, motivation and determination of the individual.

Small Limited Companies There is very little practical day-to-day difference if a very small family business is operated as a sole proprietorship or as a limited company with perhaps just two shareholders (often a wife and husband or two other closely related people) who are both directors, one the company secretary, and both sharing the functions of day-to-day management. Strictly the similarity is closer to a partnership but often there is one person who is the driving force in

© ABE and RRC Structures of Business 23 the enterprise with the other helping. The only real advantage of forming a company or sometimes buying a dormant company and getting it going again is to gain the protection of limited liability. This is a valuable protection if the enterprise runs the risk of failing with substantial debts, but for many service organisations such a risk is very small and there is no need to incur the formality and expense of a limited company.

C. PARTNERSHIPS

Some of the disadvantages of the sole trader can be overcome by forming a partnership. This increases the financial resources and widens the range of expertise available to the firm. The legal definition of a partnership was put forward in the Partnership Act 1890 and is as follows: "The relation which subsists between persons carrying on a business in common with a view of profit". So a partnership refers to people coming together to pursue common business goals. Two or more persons carrying on a business together constitute a partnership. It does not require any formal, written agreement; a verbal arrangement is sufficient. In the UK the Partnership Act 1890 limits the number of partners in a business to twenty, with some minor exceptions (including qualified and practising accountants and solicitors and the business members of a recognised stock exchange). Partnerships flourish in the same areas as sole traders. They appeal especially to professional people, who can retain a lot of individual freedom of action and maintain their personal relationship with clients while gaining the advantages of larger amounts of capital and of expertise. Partnerships are usually regulated by an agreement which covers the terms for subscribing capital, the division of profits and losses, duties, salaries and the procedures for dissolving the partnership. It is very unwise to carry on business without such an agreement. There is, then, likely to be a formal, written partnership agreement or deed of partnership. Remember, though, that a partnership may be deemed to exist by implication from the behaviour of the parties concerned, e.g. if a person shares in the profits (and losses) of a business, that person may be deemed to be a partner. The existence of a formal deed does avoid disputes on how work and profits are to be divided. Such an agreement will also make clear the date of the commencement of the partnership and, if it is to exist for a fixed period, the date on which it is to end. If it is not for a fixed period, there should be agreement on what will happen on the retirement or death of a partner. Further, unless there are procedures set down for operating and dissolving the partnership, the individual members can suddenly be faced by all the financial difficulties caused by unlimited liability for all the debts of the partnership. The key features of a partnership are as follows.  All partners have unlimited liability for the debts of the firm, just as sole traders do, so a partner could lose his/her personal wealth if the business folded up. This very heavy liability for the whole of a firm's debts applies to each partner no matter what agreement the partners may have made between themselves for sharing losses. Thus one partner could be in a position of losing everything if the other partners do not have sufficient assets, even though the losses may have been caused entirely by one of those unable to pay. It is not difficult to see why a limited company structure is likely to be preferable if there is any risk of substantial financial losses.  Any partner can bind the partnership to a contract with third parties.

 All partners are jointly liable for meeting the obligations of contracts on behalf of the partnership. The partners usually have joint and several liability, which means someone could take legal action against the partners jointly or against each partner individually, e.g. to claim damages.  A partnership, like a sole proprietorship, is not a separate legal entity like a limited company; it is the partners who are personally liable.  All partners share profits according to agreed arrangements.  The name of each partner and the business address(es) must be shown clearly on all business documents and full names of partners must be displayed at the place of business. There are two types of partnership, known as ordinary partnerships and limited partnerships. The former are by far the more popular form. Limited partnerships are those where a partner only wishes to be liable for a given amount of money which he/she invests in the partnership and not be involved in the running of the business. The Limited Partnership Act 1907 provides for a business to have general partners, who have unlimited liability but carry on all the running of the firm, and limited (or "sleeping") partners, who contribute capital but can take no part in managing the enterprise. There must be at least one general partner. Limited partners receive a fixed rate of interest on their capital. They have the protection that their liability is limited to the amount of their capital subscription. Limited partnerships are very rare, as the same purposes can be achieved by setting up a private limited company with better protection for all involved.

Advantages and Disadvantages The advantages of partnerships stem from the fact that their organisational structure lies between that of a sole proprietor and a company, so that in a sense they can obtain the best of both worlds.  Like the sole proprietor and the very small limited company, they are small enough to be flexible and the partners are close enough to the "grass roots" of the business to know what is going on. The principle of professional accountability to clients and customers is retained.  The legal and financial procedures are relatively simple – for example, the accounts of the business need only be prepared for the information of the partners and for the calculation of tax liabilities. There is no obligation to publish accounts  There can be division of labour between the partners so that each can specialise and benefit from each other's expertise in running of the business. Such working arrangements are based on trust and mutual confidence between partners.  Partnerships need not be too bureaucratic – systems and controls in the enterprise need not be too complex.  Partners may cultivate a degree of interchangeability so that if one is ill or away from the business, other partners can take over the work.  While operating as individuals, the partners can share the cost of common premises, staff and services – as in the cases of doctors, dentists and solicitors.  It is easier for partnerships to raise extra resources in order to expand or develop; unlike the sole proprietor, the partnership is likely to have more assets to use as security for loans. A partnership can also raise more capital by adding new partners. The main disadvantages of partnerships derive from shared ownership and control of the enterprise.

 General partners have unlimited liability – financial failure of the partnership can spell personal financial ruin for the partners.  The withdrawal or death of a partner may dissolve the firm.  Any partner can enter into an agreement which binds the others.  Decision-making may be difficult and slow as all the partners have to agree – one difficult partner could create problems.  For a variety of reasons partnerships are not as stable as sole trader firms. Shared control means the possibilities of disagreements and delays. Partners are human beings with human feelings; some partners may be dishonest, some may be lazy or there may be clashes of personality.

Large Professional Partnerships It is still customary and required by some professional bodies for a number of professional and semi-professional occupations – particularly legal and accountancy – to be structured as partnerships and not limited companies. It is felt that the fact that the partners have unlimited liability gives clients confidence that their affairs will be handled competently and honestly. Today, however, many such firms are very large organisations operating in many countries and providing very complex and highly skilled services to the giant multinational industrial and commercial companies. The legal responsibilities resting on the auditors and financial advisers of giant companies are very great and these companies will not hesitate to sue their professional advisers for immense financial damages if they feel that their interests have been severely damaged by an adviser's neglect, error or misjudgement. An award for damages made to a giant company could financially destroy even the largest accountancy partnership and cause heavy losses to that partnership's other clients. Accordingly the major accountancy-based firms, which are now becoming composite financial services organisations, are tending to form limited companies to carry out most of the potentially risky services for large public companies. The traditional partnership structure remains for most of the remainder of the firms' activities.

D. COMPANIES

For centuries the joint stock company has been the organisation used to bring together many investors with small amounts of capital into one large enterprise. Without limited liability they were no more than large partnerships, with all the risks that entailed.

Private and Public Limited Companies Until the passing of the Joint Stock Companies Act 1884, limited companies could only be formed by obtaining a charter from the Crown or Parliament. One early example was the East India Company, chartered by Queen Elizabeth I in 1600. Parliamentary charters are still used in special cases today, but almost all companies are formed under the various Companies Acts passed since 1884. The Companies Act 1985 differentiated between private limited companies, which must have "Limited" or "Ltd" in their names and public limited companies required to include the letters plc. Both types of company are owned by their ordinary shareholders, who hold the "equity" in the company. This is why ordinary shares are also called "equities". The liability of the shareholders is limited to their shareholding. Thus the maximum amount that they can lose is what they paid for the shares.

The main differences between private limited companies and plcs are these.  Shares in private companies can only be traded with the agreement of the shareholders; they cannot be offered to the general public.  Shares in public companies can be offered to the general public and are often, though not always, traded on stock exchanges.  A private company must have at least two shareholders while a public company must have at least seven.  A private company must have at least one director (two if the Company Secretary is a director) and a public company must have at least two directors. In general private companies are smaller businesses with much less capital than public companies. However there are some small plcs. The advantage of forming a private company is that one can raise more capital with limited liability while still retaining control. Many are family businesses and most professional clubs are private companies. Public companies are formed to tap the much wider sources of capital by selling shares direct to the public, through the Stock Exchange, or by placing them with investing institutions like insurance companies, pension funds and investment trusts, which are themselves public companies formed specifically to invest in the shares of other companies.

Formation of a Company When any limited company is formed, the promoters have to file certain documents with the Registrar of Joint Stock Companies and obtain a Certificate of Incorporation. The main documents are the Memorandum of Association which sets out the objectives of the company, its capital, borrowing powers and name; and the Articles of Association which cover points like the powers of directors, rules for issuing and transferring shares, arrangements for company meetings and other internal affairs. A public company also produces a prospectus setting out the terms on which it offers its shares and the history of the firm and its prospects.

Finance Companies issue different classes of share in order to appeal to different types of investor. Shareholders receive dividends, which represent a percentage of the profits. Companies also borrow by issuing debentures, which represent a loan to the business and which receive interest at a fixed rate. A public company can offer its securities direct to the public or place them with investing institutions. The institutions also buy shares on the Stock Exchange (which deals in second-hand shares and debentures). Investors in public companies have the added security of knowing that they can sell their shares freely at any time through the Stock Exchange. Shareholders in private companies do not have this advantage. The types of security are as follows.  Ordinary shares, which receive a dividend determined by the Board of Directors according to the size of the profits. Ordinary shareholders are the owners of the company and each share entitles them to one vote at company meetings.  Preference shares, which receive a fixed rate of dividend before any other class of shareholder is paid anything. Some preference shares have the benefit of being cumulative, which means that any unpaid dividends are carried forward until there is enough profit to cover them.  Debentures are stocks, not shares, and represent a loan to the company. They are not part of the share capital. Debenture holders are creditors of the business and receive a fixed rate of interest; they take no part in running the company.

Structure Companies are controlled by their owners, the ordinary shareholders, who can vote at the Annual General Meeting to appoint or remove the directors who manage the business. Directors may be executive, responsible for specific functions, or non-executive, representing the general interest of the shareholders. The voluntary code of corporate governance set out by the Cadbury Committee advises all plcs to have non-executive directors who can take an independent view of the management. The structure, functions and interrelationships of a joint stock company are shown in a basic form in Figure 2.1. You should note the following aspects of this structure.  The shareholders (who may hold ordinary, preference or both types of shares) are the owners of the firm.  The Board of Directors is responsible for: (a) Formulating policies. (b) Ensuring that these policies are implemented. (c) Ensuring that the enterprise has an appropriate structure and sufficient resources to achieve its objectives. (d) Ensuring that the company operates within the law of the country. (e) Looking after the interests of the shareholders. The Board of Directors may be made up of both full- and part-time directors. Normally full-time directors will be responsible for the running of certain important areas of the firm, e.g. accounts/finance, production, marketing, etc. Part-time directors (non-executive) have sometimes been criticised as expensive passengers, being paid their fees just to add a reputable name to the list of directors. However, experts now argue that non-executive directors perform a valuable role. Firstly, because of their part-time status they can take a more impartial view of the firm and can act as referees when there are disputes between various parts of the organisation. In addition, many non-executive directors are experts in their own right, e.g. lawyers, accountants, property specialists. Non-executive directors may have valuable business contacts that can be used to assist the firm. However, there are disadvantages associated with part-time, non-executive directors. It can be argued that their time is limited and that their outside interests distract from their commitment to the firm. Supporters of full-time directors point to the way that their total commitment to the one firm ensures loyalty. Full-time directors can see their ideas followed through from planning to execution; they can take on the running of important sections of the firm. These directors can appoint managers to assist with the running of the firm.  The Chairperson is the head of the Board of Directors. He or she chairs the board meetings and delivers the annual company report. Although a chairperson is sometimes part-time, he or she is normally a very experienced business person who can guide the board and obtain the best contribution from the other directors.  Next we come to the Managing Director. This is a position of considerable power and responsibility; the Managing Director sees to it that the policies and decisions of the board are translated into actual performance. The Managing Director runs the company through his or her department managers (some of whom may be directors). Each of the department managers has charge of an important area of the organisation.

 Finally we have the department managers. Some important departments may be managed by full-time directors with non-director managers to assist them. The crucial point is that all key departments must have a person in charge and responsible to the Board of Directors.

SHAREHOLDERS Own the assets of the firm. Have limited liability.

Preference Shares Ordinary Shares Fixed dividend paid before Voting rights to elect ordinary share dividends. directors.

BOARD OF DIRECTORS Run the business, formulate policy, look after shareholders' interests.

CHAIRPERSON Chairs board meetings and delivers Annual Report.

MANAGING DIRECTOR Responsible for the running of the firm.

DEPARTMENT MANAGERS Managers in charge of the various departments of the firm, e.g. production, marketing, personnel, accounts, administration, research.

Figure 2.1: General Structure of a Limited Company

Note, too, the way in which the elements are interrelated.  Shareholders and directors There is a two-way link between these two groups: ordinary shareholders have voting rights to elect directors, while directors have the responsibility of looking after the interests of all shareholders.  Chairperson and Managing Director In many companies the Chairperson may be selected from the non-executive directors; in other companies the roles of Chairperson and Managing Director are combined in a single person, sometimes known as an "Executive Chairperson". Even when the roles are separate there has to be a good working relationship between the Chairperson and Managing Director.  Directors and departmental managers Again these are roles which can sometimes be combined: functional directors can manage a given department while successful managers may be appointed to the board and become directors.

Advantages and Disadvantages The advantages of the public limited company (plc), the dominant form of company in the commercial sector, are as follows:  The company enjoys the legal status of incorporation, which means that it has an existence and identity apart from the people who set it up and those who work in it. Shareholders, directors and employees may retire or die, but the company lives on.  There is continuity of succession, because the continuation and legal standing of a company are not affected by the death of a member or withdrawal of a director.  Companies have a separate legal entity from the shareholders who, therefore, cannot be sued for the actions of the company.  Those who invest in limited companies have limited liability so may be more ready to take a limited risk.  Ownership is largely separate from control, so the company may be run by professional managers who, if they fail to perform well, can be replaced. Investors can put money into shares without taking any responsibility for running the company.  Large amounts of capital can be raised from large numbers of investors, especially for new and more risky ventures. (But private companies can approach only a limited number of members.)  Stocks and shares can easily be transferred so that investors can recover their capital.  The larger scale of operations of public companies and larger private companies makes it possible to employ specialist managers.  Control of a company is obtained by owning 51% of its ordinary shares, so that it is possible to build up large groups of companies through a holding company which holds shares in the subsidiaries. Whilst these advantages are strong, you should recognise that there are disbenefits from this form of business organisation.  The procedures for setting up a company are costly and complicated compared to starting other forms of enterprise.  Detailed annual accounts have to be prepared, audited and submitted to the Registrar, an Annual Report made to shareholders, and a register of shareholdings has to be

maintained. (Smaller companies, in terms of turnover, have a lesser burden in this respect.) The publication of balance sheets, share prices and reports may assist competitors.  Shareholders have little control in practice, as individual shareholdings tend to be small and most shares are held by the investing institutions and unit trusts, which have rarely taken an interest in the management of the firms in which they hold shares.  Small and new companies may find it difficult to borrow or get credit because lenders know that limited liability may make it impossible to get their money back.  Managers are unlikely to put in as much effort as the sole trader or partners. Incentive schemes for directors and senior managers have been severely criticised as too generous, and the Cadbury Committee recommended that non-executive directors should decide pay and incentives for these senior people.  Professional managers may put their interests and careers before the interests of the shareholders, indulging in "empire building" and drawing high salaries and expenses not fully justified by their performance.  Companies may become large and bureaucratic, which can lead to a slow response to change or new opportunities.  Public companies are vulnerable to take-over bids from rivals who make an offer to buy their shares.

E. PUBLIC SECTOR ORGANISATIONS

The public sector includes nationalised industries (public corporations), local government bodies, government agencies, and quangos – quasi-autonomous non-government organisations responsible to a government minister. They have a wide range of objectives which we will look at shortly. Public enterprise does not include the social services which are not run on business lines.

Public Corporations These are effectively public companies set up by Act of Parliament. A nationalised industry is one where the firms have been taken into public ownership in a public corporation. The BBC was established as a public corporation before the Second World War. After the War, several industries were nationalised and the firms reorganised into corporations like British Steel, British Overseas and British European Airways, and British Rail. Most have been privatised during the post-1979 period, as we have seen, and shares in them sold to the general public as they turned into public limited companies. The Act which establishes a public corporation plays the part that the Memorandum and Articles do for a company. Any capital is held by the Treasury. There are no shareholders. The relevant minister appoints the board which manages the corporation. The minister and the Treasury agree on borrowing limits. A corporation is a legal entity, but the minister is responsible to Parliament for the running of the industry. Privatised industries where there is little competition are overseen by a regulator, like Ofgas for the gas industry and Oftel for telecommunications. The regulator has to agree pricing in accordance with a formula laid down by Parliament. For example, the water companies' price rises are limited to a percentage below the rate of inflation. As the government sells off any remaining stakes in these industries and permits more competitors to enter, the role of the regulator is likely to change towards ensuring effective competition rather than fixing prices.

Municipal Enterprises Local authorities engage in a range of commercial activities. These range from renting market stalls to operating public transport. Trading activities exist to earn a profit, but most are also operated to provide a service. For example, the local sports centre may be expected to make a profit on its restaurant and bar, but to provide keep-fit classes for pensioners and children's holiday activities at less than cost. The aim is to make the service available to the residents more efficiently or cheaply than would a private enterprise. Since 1980, in order to ensure efficiency and value for money, the government has required a number of local government activities to be put out to competitive tender and local authority departments have to compete for work with private firms. The Direct Labour Organisations which maintain houses, roads and refuse collection are examples of services which have to be competitive. In all cases the service will be overseen by an officer of the council who is responsible to a committee of the council. Local authorities are subject to government spending and borrowing limits and the amount they can raise in council tax on property values is controlled. Most of the income of the authorities comes from government grants based on a formula related to the population and needs of the area. Most of this money is earmarked for specific services like education, so local authorities are keen to earn as much as possible from trading which they can spend on local amenities as they please.

Quangos Depending on which definition you accept, there are about 1,300 or 5,500 bodies which carry out some function on behalf of the government. The lower figure is the government's own estimate, the higher includes all the National Health Units, opted-out schools, agencies and other bodies funded by the government. All quangos have powers delegated to them by a minister who appoints the members of the board and provides for finance. Some quangos are self-financing from fees and licences, others get their income from the government. Many are not strictly business organisations but their activities have an important impact on business. Examples include the Competition Commission, which monitors restrictions on trade and makes recommendations to the minister on proposed mergers. The Equality and Human Rights Commission, British Tourist Authority and the Advisory, Conciliation and Arbitration Service, which tries to resolve disputes between employers and workers, are other examples of quangos. The wider definition of quangos would include National Health Hospital Trusts, and agencies that have taken over functions formerly performed by government departments like Paymaster Services, which pays out all the pensions of ex-public employees. Many of these are trading organisations – for example, hospital trusts sell their services to fund-holding general practices and regional Health Authorities. Certain other government agencies can compete with private firms to attract business from other sources. The aim of setting up such organisations is to get the advantages of market efficiency while retaining a measure of government control.

The Public Enterprise and State Ownership Debate There are strong arguments for the involvement of government or governmental bodies in business enterprise. These include.  Some goods and services are natural monopolies – that is, they can have only one supplier. Water and sewage supplied to households and business premises are good examples. There is no point in having half a dozen water taps so that the drinker has a

choice of Chiltern, Thames, Welsh or other water. Public ownership is supposed to prevent exploitation of the consumer by the monopoly.  Some activities are not profit-making but are essential for the community, so they tend to be performed by central or local government. Local social services for the elderly and disabled and street lighting are examples. The Post Office delivers to all addresses for a uniform fee regardless of how remote they are.  The scale of an enterprise may require very large amounts of capital on which there is no prospect of any return for several years, as in building nuclear power stations. Only the State can provide the resources.  It is generally felt that some activities should be free from the political bias or control which could result from their being in private hands. This was the argument for public ownership of the BBC, and for making it a public corporation with a charter giving independence from government interference.  Some activities, like military aircraft, are of vital strategic importance and should not be at risk of falling into foreign hands.  Most nationalisation in the UK and other countries has come about because of the political belief that the State should control the major means of production, distribution and exchange in the economy.  Some industries and firms have been brought into public ownership because they were bankrupt and a private buyer with the means to reorganise the industry could not be found. The immediate aim has been to protect jobs. This was the case with British Leyland, the motor vehicles group, which became Rover Group and was privatised when it was subsequently sold by the government to British Aerospace. On the other hand, strong arguments may be advanced against public enterprise and state ownership.  Losses are carried by taxpayers, which may encourage inefficiency and waste.  Political pressures and decisions may cause losses, unsound investments and uneconomic activities. For example, at one time the electricity industry was forced to operate at a loss covered by government borrowing.  Public accountability means that managers are excessively cautious and innovation is stifled or delayed.  Nationalised industries' capital is provided by the government. When there are restrictions on government spending, the industries are unable to invest in profitable ventures. Private firms, on the other hand, can always go to the market for finance.  The scope of the business may be restricted by the terms of the relevant Act or charter. For example, British Telecom and some water companies have won a lot of overseas business since they were privatised, something they could not do when in public ownership.  Even though an industry may be a natural monopoly, the initial supply of the product need not be a monopoly or in public ownership. For example, electricity can be supplied to the grid by independent generators who compete for the work. Control over the local retail suppliers who connect the households can be through the appointment of a regulator. The industry can secure the advantages of competition and government supervision without the need for public ownership.  Where essential services are uneconomic for private firms, they can be subsidised by the government. Firms can compete for the business, ensuring that the desired level of service is provided at the lowest cost.

 "Blanket" subsidy can lead to wasteful over-production. The public wants the highest level of service, but is unwilling to bear the direct costs; so political pressures lead to subsidies and thence to inefficient use of resources.

F. NOT-FOR-PROFIT ORGANISATIONS

There are a number of non-commercial organisations which offer services and do not generate profits for shareholders. Such organisations may be profitable but these returns are passed on to selected recipients or members of the organisations. Such organisations include clubs, societies and charities which are formed with many different objectives. For example:  a club may exist to provide golfing facilities for its members like the Royal and Ancient at St. Andrews;  a learned society to further studies and education in its specialist field like the Royal Horticultural Society;  charities cover just about every aspect of life from the National Trust, which owns and preserves properties and open spaces, to the Friends of a local Hospice for the very ill;  professional bodies provide qualifications and education, information services, recruitment and employment bureaux and meeting places for their members;  trade associations exist to provide services to their member firms – usually undertaking public relations and advertising for the trade as a whole, publishing trade magazines, providing an information service and arranging trade fairs and exhibitions. They may also offer an arbitration service, run an insurance scheme to protect customers against faulty work or bankruptcy of members, and have joint research facilities. Although they do not exist to make a profit, many of these organisations end the year with a surplus of income over expenditure from their trading activities. They will also have income from membership fees, donations and bequests. What makes them different from commercial organisations is that they apply their income and surpluses to furthering the purposes of the club, society or charity and not to paying dividends to shareholders. The types of organisation are as varied as the reasons for their existence.  Charities and professional bodies are often companies limited by guarantee, run by a board – elected on the basis of one member, one vote – and managed by a professional staff. Charities are organisations which raise funds for specific causes and people deemed to be in need. Charities must register themselves in much the same way as companies, but with the Charity Commission. They establish the limits within which they will operate, and are required to file Annual Reports. Given that they have very different objectives from a commercial concern, they are to all intents and purposes much like a limited company.  Clubs and societies may seem far removed from the world of large-scale operations, but they, too, have the basic organisational characteristics of specific goals, the need for resources to meet the needs of their members, a recognisable structure (chairpersons, committees, treasurers, secretaries, etc.), and information systems. Thus, they are likely to have a constitution and be run by an elected committee, although this is not always the case. Some rely entirely on volunteers from the members – members of the local football club, for example, may cut the grass, wash the kit and run the bar in the clubroom – whilst others may employ professional staff to carry out all the business for the committee.

G. OBJECTIVES OF ORGANISATIONS

There are many different objectives which different types of organisation may pursue, and indeed an organisation may try to achieve different aims at various times. For example, a business may try to maximise its share of the market in order to go for profit maximisation later. One objective will not be pursued to the exclusion of all others, though. Remember that organisations are set up for a purpose and their objectives will relate to that purpose. If an organisation loses sight of its main objective or puts too much effort into trying to achieve other aims, the owners, members or other stakeholders may leave or close it down. Let's consider the major objectives which organisations have.  Survival is the first objective of a business that is to reach a sustainable sales level that allows the firm to break-even. Unless a business can achieve this objective it will close as soon as initial capital is exhausted. Once a firm has reached a sustainable level of sales it might change its objective to one of profit maximisation.  Profitability is essential if enterprises are to continue in business in the longer term. The level of profit is important to those stakeholders who depend on the organisation for an income; it must be sufficient to make it worthwhile to retain the assets in that line of business. Economic theory says that businesses should have the over-riding goal of profit maximisation. This is because it is a measurable objective which can be applied to all types of business. In practice firms are unlikely to try for it all the time; they will seek to achieve some accounting measure like a level of return on capital employed (ROCE) or income per share.  Market penetration is an important short-term objective when a firm enters a new market and wants to achieve a viable level of sales. For example, a firm may set a target of 15% of the market in order to be able to earn enough profit to cover the cost of entry.  Market share is often a longer-term objective. It is linked to competitive advantage whereby a firm attempts to achieve and maintain its position in the market.  Sales maximisation is an objective which appeals to managers who are paid bonuses linked to increases in revenue. Managers can often pursue their own objectives so long as they make enough profit to keep the shareholders happy.  Revenue maximisation can be the prime objective of organisations like bus companies which are paid a subsidy by a local authority to run rural services. The subsidy covers the cost of providing the service after allowing for a certain number of ticket sales, and any additional revenue is a bonus for the firm; there may be all sorts of special offers to get more people to travel. It is also the objective of charities subject to minimum costs.  Satisficing is likely to be the realistic objective of large organisations with several divisions or subsidiaries. It is impossible for the enterprise to pursue one single objective. Because all the parts of the firm may have different goals, a minimum level of achievement is set for the organisation as a whole. It is said to "satisfice" instead of maximise. Setting an overall minimum avoids conflict between the parts of the organisation.  Level of service is the objective of organisations in the public sector and in not-for- profit areas. They may aim at the highest possible level of service or at the best attainable service for a given cost. The Health Service is an example. Business firms also have a high standard of service to customers as an objective. It is an increasingly important method of competing.  Technical excellence is an objective of research organisations and engineering firms. Innovation and technological advances may be seen as more important than sales or

profit maximisation. The pursuit of excellence may bring the kind of reputation which builds sales and profit in the longer term, Rolls Royce cars are a good example. Organisations may have other objectives like environmental protection and staff development. Whatever objectives they try to achieve, singly or together, the ultimate aim is survival.

Study Unit 3 Structures of Organisations

Contents Page

Introduction 38

A. Formal and Informal Structures 39

B. Infrastructure 39 Line Organisation 39 Staff Organisation 42

C. The Functional Departments of a Business 43 Marketing 44 Production 44 Finance and Accounting 45 Personnel Error! Bookmark not defined. Research and Development 46 Data Processing 46 Contracting-Out of Functions 46

INTRODUCTION

The ownership of an organisation, and what that organisation is set up to do, determine how it is structured. A business which produces and markets many products has a choice of whether it structures itself along product or market lines. It also has to decide on the "shape" of the organisation, including whether the firm's management is centralised or decentralised, whether all operations come under one line of control or whether support functions are separate – these are decisions which can mean success or failure in today's rapidly changing market place. Structures must allow for change and development in order to enable the organisation to respond to technical innovations, social and environmental developments and, above all, competition. Small organisations cannot afford too much specialisation. The accountant in a small firm has to be credit manager, cost clerk, wages clerk, purchasing controller and data processing manager as well. In large businesses there has to be much greater specialisation in order to cope with the work. Unless the enterprise is structured for efficiency and effective management, there can easily be a loss of co-operation and control; departments can go their own way and communication can be poor. Any structure must reflect the priorities of the business and be capable of development to adapt to changes in the organisation's environment and objectives. Every organisation must have some system for working so that it achieves its objectives, otherwise it will muddle along and be constantly "fire fighting" problems without making progress. The larger the organisation, the more complex its structure is likely to become. All organisations require a system for:  Planning and decision-making  Implementing decisions through a structure of authority and delegation  Organising work into functions so that people can specialise and decisions are carried out efficiently. Different structures are used to provide these systems. They all require good communication in order to ensure that plans and decisions are made on the basis of informed knowledge and that decisions are understood and carried out effectively. Objectives When you have completed this study unit you will be able to:  Distinguish between the formal and informal organisation.  Distinguish between line and staff relationships.  Describe the ways in which the infrastructure of an organisation may be arranged.  Outline the functions and operations of the different divisions and departments of a business.

A. FORMAL AND INFORMAL STRUCTURES

In studying the structure of organisations we need to distinguish between informal structures, such as friendship groups at work, and formal organisational structure. In large companies the two are quite distinct and, indeed, in some companies any tendency for overlapping is discouraged. In small, especially small family-controlled, organisations the two can be intertwined. This has its advantages but also its dangers. Information can often flow freely without time-consuming and frustrating formal communication networks, but personalities can damage business effectiveness and a family row or division can literally wreck the business. More seriously, a strong and effective informal structure can make it extremely difficult for the successful, family-managed or individual-entrepreneur-dominated company to transform itself into the kind of professionally managed corporate organisation that the financial institutions of the capital market expect in a large public company. The professional managers, introduced perhaps at the insistence of the institutions, can find themselves in conflict with the informal structure and the whole organisation fractures or implodes into a decision-making "black hole". This study unit is based on what could be expected in an established public company. The formal structure of an organisation may be defined as the way in which areas of responsibility are allocated and organised. It is the formal structure that gives an organisation its shape, like the skeleton of the human body. Formal organisational structure is made up of two basic parts:  The infrastructure is the way in which authority is allocated in an organisation.  The superstructure is the way in which employees are grouped into various departments or sections. Both infrastructure and superstructure can take a variety of forms which we shall examine in the following sections.

B. INFRASTRUCTURE

There is a basic distinction between two different types of authority in organisation – line and staff. Line relationships have traditionally been the most important in shaping the structure of the organisation.

Line Organisation This is a form of organisation where the lines of authority are direct, i.e. they link superior and subordinate directly. There is unity of command, which means that each subordinate knows from whom he/she is to take orders. At its simplest, line organisation is a direct flow from the top of an organisation to the bottom. All line organisation is hierarchical, i.e. it flows down through various levels of authority. This is sometimes termed a scalar chain, referring to the chain of command from relatively few superiors to growing numbers of subordinates. This results in pyramid structure in which authority and responsibility extend downwards in a hierarchy as illustrated in Figure 3.1. Information about plans and decisions is communicated downwards through the levels of the hierarchy. Control information is communicated upwards so that more senior levels of management know how well targets are being met: this will include information on sales, output, stocks, orders and finance.

Figure 3.1: The Hierarchical Line Organisation

The crucial features of hierarchical line organisation were identified by the early 20th century writer Henri Fayol. He set these down as "principles" of management which have been highly influential in shaping organisational structures. These principles are:  Objectives: every organisation must have clear objectives.  Authority: there must be a clear line of authority.  Responsibility: where a person is given responsibility, he/she must also be given the authority necessary to carry out the task. A superior can be held responsible for the actions of his/her subordinates.  Specialisation: as far as possible people should specialise in order to be proficient.  Definition of tasks: employees should know exactly what is expected of them.  Unity of effort: everyone in the organisation should be working towards achieving the goals of the organisation.  Unity of command: each member of the organisation should have one clear superior to whom he/she is responsible. The span of control should not be too wide; ideally no person should supervise more than five or six subordinates. We shall return to these later in the unit to consider their usefulness. We can classify line organisations by reference to the two aspects of the structure. (a) Tall or flat structures Tall structures have many levels, as illustrated by Figure 3.2.

Managing Director

Directors/Divisional Managers

Department Managers

Section Heads

Team Leaders

Supervisors

Operatives

Figure 3.2: Tall Organisational Structure

The advantage of tall structures is that there is a clear division of work between the various levels; this fits well with clear line authority. The disadvantages include:  Possible confusion of objectives between the numerous levels.  A long ladder of promotion, which may discourage those at the bottom.  Tall structures tend to be bureaucratic, spawning an increasing number of levels. A flat structure has relatively few organisational levels, as shown by Figure 3.3.

Managing Director

Department Managers

Team Leaders

Operatives

Figure 3.3: Flat Organisational Structure

The advantages of flat structures are the short ladder of promotion and smaller risk of divergence between the objectives of one level and another. Flat structures tend to be more flexible and less bureaucratic. The disadvantage of a flat structure is that it requires greater flexibility at all levels, with people being prepared to undertake a wider range of activities. This calls for dedicated and well-trained employees.

(b) Wide or narrow spans of control The span of a manager's or supervisor's control refers to the number of subordinates which he/she controls. When many subordinates are controlled and report to a given supervisor, the span is said to be wide; when few subordinates are controlled by a superior the span is said to be narrow. It is important that the span of control is appropriate for the type of duties being supervised. Complex work normally requires a narrow span of control; likewise, inexperienced staff need close supervision so a narrow span of control is appropriate. In contrast, workers doing relatively simple tasks can be controlled in larger numbers (a wide span) and well-trained, experienced workers can operate with a wide span of control. Another factor affecting the span of control is the experience and quality of the manager or supervisor; the more able the manager, the wider the span of control he/she can operate. So the key variables in deciding on the width of the span of control are:  The nature of the work;  The quality of the operatives;  The quality of the manager or supervisor. There is often a relationship between the height of the structure and the span of control. Narrow spans of control may be associated with tall structures (the many levels may have fewer people to control); wide spans of control may be associated with flat structures (the fewer levels may have more people to control). In recent years, there has been a reaction against the hierarchical type of organisation shown in Figure 3.1. Instead of the "tall" structure shown there, with several layers of management and supervision, firms have been changing to "flat" organisation structures. Layers of middle management have been cut out as responsibility for decisions and functions has been pushed down to the lowest practicable level in the business. British Telecom, for instance, shed many personnel as it removed layers of middle managers and supervisors, and by 1994 it was reducing the number of senior managers as well. A better educated and trained workforce means that employees can be given the opportunity to manage their own work. New technology, especially in computers and information technology, has made it possible for shop floor workers to schedule, control and maintain their machinery and organise their workload. Employee empowerment is the key to better motivated staff as people take responsibility for their own jobs.

Staff Organisation In contrast to line organisation, staff structures exist to provide specialist information, service functions, and expert advice and guidance to other departments in the organisation. A typical example is the financial information and guidance provided by the accounting department to other parts of the organisation. Other staff departments are administration, personnel, research and development, etc. Problems may arise when staff department experts try to control the conduct of line managers in other departments. Line managers may reject the guidance being offered to them, because they feel that it is they who will carry the ultimate responsibility for their department's performance. Many line managers resent the interference of staff "experts" whom they consider to be too "theoretical". Some experts argue that the presence of both line and staff managers complicates the structure of authority because it breaches the principle of "unity of command". The situation is further complicated by the fact that staff managers are themselves line managers in their own departments. For example, the manager of an accounting department

© ABE and RRC Structures of Organisations 43 exercises line authority over his/her own subordinates and may resent the intrusion of "advice" from a staff manager from, perhaps, the personnel department. The concept of functional authority has been developed to help resolve the problems described above. Experts argue that the core of the problem is that the staff manager lacks clear authority to instruct line managers in other departments; advice or persuasion are not strong enough techniques to ensure compliance. Functional authority gives the staff manager the clear right to instruct line managers in other departments on certain specified activities or procedures wherever, in the organisation, these are being undertaken, e.g. the personnel manager may be given functional authority over redundancies in all departments of the organisation, or the accounting/finance manager may be given authority over budgetary planning and control of other departments. Within these specified areas the staff expert's authority takes precedence over that of the line manager, but in all other areas the line manager's authority is unquestioned. So, in many modern organisations the manager of a service department, like accounting, will be a line manager within his/her own department and a staff manager with specified functional authority in other departments of the organisation. Although functional authority works well at the higher levels, problems may arise when accounts or personnel assistants are sent in to work in other departments, e.g. production or marketing. These assistants may be called upon to report both to their staff managers and to the line manager of the department in which they are located. Very clear guidelines are required.

C. THE FUNCTIONAL DEPARTMENTS OF A BUSINESS

All organisations engage in a similar range of basic functions regardless of the size or purpose of the organisation. Obviously, the importance of each function varies according to the size and objectives of the organisation, but whether we consider a church, a sole trader or a large multinational enterprise, we will find a similar range of commercial, technical, financial, accounting, personnel, security and managerial functions. Thus, a church has commercial activities when it buys and sells books of prayer and instruction, makes charitable donations and charges fees for weddings. Its technical functions are to produce services and social events like a youth club. Finance covers decisions on the use of funds and bequests. Accounting is necessary for the control of stocks and for budgets for maintenance. Personnel covers the work of clergy and volunteers. Security is necessary to safeguard premises and possessions. Management plans, organises and co-ordinates all the other activities. A sole trader has the same requirements, but has to manage and carry them out alone. Bearing in mind that the relative importance of each function depends on the size and activities of the enterprise, we can look at each of them briefly and then, in more detail, at how they are carried out by the various departments.  Commercial activities include selling products and services and buying in materials and components.  Technical functions cover the production of goods and services and involve the necessary support functions like quality control.  Financial activities are concerned with the utilisation of funds to carry out budgeted activities.  Accounting services include the preparation of estimates, collecting statistics, analysing costs, managing credit and preparing accounts.

 Personnel covers all aspects of managing people – job design, recruitment, training, appraisal and record keeping.  Security is essential to safeguard people, premises and materials.  Management plans, organises, co-ordinates and controls all the activities of the organisation. The nature of the departments set up to carry out these functions may differ from one organisation to another (for example, in a college, the production departments are the teaching units providing business studies, science and so on) but the purpose is the same. In smaller organisations, some of the functions may be merged. A general classification of the main functional areas of business would include the following.

Marketing Marketing is concerned with the whole activity of the business. It covers the whole process from research into new products through to sale. Selling is only one aspect of marketing – the department is also concerned with market research, advertising, sales promotion, public relations, selling and distribution, servicing and payment, and credit. All of these activities we will examine in detail later in the course. A large company will have a Marketing Director with managers for each of the functions. The sales and service managers will have product and area organisations with local managers of branches. For example, the company may sell and service washing machines and refrigerators through local branches with a product manager who sells to large trade customers. The marketing manager is concerned with advertising – most often actually carried out by an advertising agency – sales promotions like competitions and free gifts, and public relations (PR) including press releases about new products. PR may be a separate function and include corporate activities like community events and sponsorship. Market research is concerned with identifying customer requirements and attitudes, collecting information about products and markets, and identifying market opportunities and strategies.

Production The objective of the production department is to provide to the marketing organisation an agreed quantity of products according to the delivery plan. Products have to be of the right quality and made at the right cost. The main types of production organisation are:  Jobbing, where each job is distinct from every other and usually has to be completed in one stage of production. Printing posters and sales leaflets is an example where each job stands alone.  Batch production, where similar parts are produced in batches and then assembled together, as in making toys like dolls where arms, legs, bodies and heads are made separately.  Flow production, where the product is built up in stages as it moves along the production process, like cars moving through body assembly and paint shop, with engine and transmission, seats and carpets, wheels and tyres being added as the vehicle moves along the production line.  Process production, where a continuous process is used to make chemicals and some foods. Oil refining is a good example – raw materials are fed in at one end of the process and final products – aviation spirit, paraffin, lubricants, petrol, diesel, heating oils – are drawn off as refining proceeds. Quality control is an essential part of production and involves setting standards, checking materials and components, monitoring production and following up sales. Quality control is

© ABE and RRC Structures of Organisations 45 equally vital in services and many stores, banks, hotels and transport firms employ specialist agencies which send inspectors posing as customers to check on the way real customers are treated. Purchasing may be part of the production department or may stand alone – it is involved with all of the other departments. The first stages of purchasing are concerned with specifying and sourcing materials and components. Then come enquiries, negotiation and ordering followed by processing despatch, receipt and inspection and, finally, invoice acceptance. With the spread of just-in-time manufacturing, where parts are delivered to the factory continuously as they are required in the production process, purchasing and stock control are increasingly important functions. Purchasing is becoming much more of a process of sourcing materials, parts and equipment worldwide, as industrial activity is dispersed over the globe and firms buy in components rather than make the parts themselves. Stock control and stores management are also part of production.

Finance and Accounting The Finance Director has responsibility for all the finance and accounting functions. These include obtaining the funds required to run the business – either capital raised through share issues, or borrowing long term by debentures or short term for working capital. These funds have to be managed, and that is the job of the Treasury Department. In very large organisations this may include foreign exchange dealing. BP, for example, has its own foreign exchange dealing room to do business with the banks. The finance department is also responsible for the provision of information to the board, shareholders and tax authorities, so it has to produce all the financial accounts required by law and the information for investors and analysts. There has to be an organisation to deal with pay and pensions. Internal budgets and financial information have to be produced for every department and section. This may be carried out by the costing and management accounting sections which also produce control information. Credit management and control are important functions and can form a large department in firms which do a lot of credit business with large numbers of customers. Ensuring payment on time is essential for managing the cash flow.

Human Resources Other than their own staff, HR Managers do not manage people. They are responsible for human resources across the whole organisation – planning for requirements at all levels, job descriptions, recruitment, training and education programmes, evaluation and appraisal programmes, pay, rewards and incentives, pensions and employee schemes. Much of this work may actually be carried out by line managers – for example, annual appraisal interviews – but it is co-ordinated by the HR department. The HR Manager has to be aware of competitive conditions in other companies and industries which can attract the same types of skilled workers. There may be negotiations with trade unions at national officer level on pay and conditions, or at factory and office level with local shop stewards and representatives. The HR department has to ensure that statutory requirements are met, including those concerning health and safety at work. Record keeping is an important part of the work, both for the company's internal purposes and to comply with the regulations.

Research and Development Research is carried out into new products and ways of improving existing ones. Development is the process of planning, making prototypes, setting up feasible manufacturing processes and generally bringing ideas to production and sale. It is important that a firm should have a constant flow of new or updated products to replace those which have reached the end of their commercial life. R&D has to liase closely with marketing, production and purchasing.

Data Processing Personal computers (PCs) are now on virtually every desk and can be networked into systems linking everyone in an organisation. They have transformed methods of working in the last ten years. Although the PC supplies all the processing power needed by many firms, many others require huge amounts of processing power. Thus banks and building societies have to have huge capacity to cope with real-time processing of withdrawals from cash dispensers and all the other entries on customers' accounts. Supermarkets use direct computer links between tills and warehouses for overnight stock control and supply. Banks and other firms with large systems necessary to cope with peak loads often carry out work for others at off-peak times. This is advantageous to the business, which does not then have to invest in a lot of processing capacity and specialist staff for its payroll function, for example.

Contracting-Out of Functions As you can see from the descriptions of departmental functions, the larger the organisation the more interdependent are its parts and the greater the problems of communication, co- ordination and control. Organisations can attempt to overcome some of the problems by contracting out functions to specialists, for example advertising to advertising agencies and facilities management to specialists in property management, office cleaning and data processing. This also makes it feasible for small firms to enjoy some of the advantages of large ones.

Study Unit 4 Organisations in their Environment

Contents Page

Introduction 48

A. Analysing the Environment 48 Political Environment 49 Economic Environment 49 Social Environment 50 Technological Environment 50 Ecological Environment 51 Legal Environment 51

B. Stakeholders 52 The Interests of Stakeholders 52 Conflicts of Interest 54 Stakeholder Influence 55

C. Responding to Change in the Environment 57 Political Change and its Impact on Business 57 Economic Change 57 Social Change 58 Technological Change 58

D. Services to Business 59 Banking Services 59 Other Financial Service Providers 60 Consultancies 61 Government Services to Business 62

E. Location of Industry 63 Factors Determining Location 63 Government Influence on Location 65 Environmental Change and Location 66

INTRODUCTION

All organisations exist within interrelated environments. They face threats and can find opportunities within the national and international economic and political environments. The social environment influences the behaviour of organisations and determines how they are viewed by stakeholders, politicians and the wider public. Technology brings threats and opportunities, and affects the structure and working methods of the organisation. The legal environment provides a framework within which organisations must work and it reflects the concerns and interests of society and politicians. All organisations have to be concerned with their ecological environment, both because of the effects of their own activities on it and because of the view taken of their activities by stakeholders and society. Changes in the environment affect organisations. How well the undertaking plans and organises to meet change, determines whether it will survive and prosper or fail and disappear. Over time many organisations have transformed themselves to deal with change; some have sought new activities and abandoned the old. Change affects the stakeholders in an organisation, not least the workers. The attitudes of stakeholders are shaped by their environment. This determines their view of how the organisation should operate and how it should respond to change. Objectives When you have completed this study unit you will be able to:  Describe the various environments within which the organisation exists.  Explain how each of these environments affects the organisation in terms of its policies, structure and operations.  Discuss how organisations respond to changes in their environment.  Describe the range of services available to business organisations in their environment.  Explain the factors influencing the location of businesses.

A. ANALYSING THE ENVIRONMENT

All organisations exist within their environment. The normal way of looking at that environment is to conduct what is called a PEST analysis. The initials stand for:  Political  Economic  Social  Technological More recently, this analysis has been extended to take into account two further features of the environment:  Ecological  Legal Thus, it may help to remember the whole range of factors as PESTEL. Each of these environments affects the organisation, and each has impacts on all of the others. For example, social concern about pollution influences political thinking, which leads to legislation. Existing technology may then be affected by the banning or restriction of activities and new solutions have to be found which satisfy ecological criteria. The impacts may be much wider than the purely local circumstances of an individual business

© ABE and RRC Organisations in their Environment 49 organisation. For example, concern about the effects of CFC gas used in refrigeration on the ozone layer led governments internationally to adopt targets for replacing the harmful substance and individual nations passed laws banning the use of CFCs by a certain date. New materials had to be developed and tested to ensure that they did not cause ecological damage. Technological change was necessary to change manufacturing processes. Many individual organisations have been affected by these changes in the environment. All refrigeration plants had to ensure that they complied with the new regulations; manufacturers had to develop new materials; public sector laboratories and pollution inspectorates had to develop systems for testing and measuring; banks which had lent money to polluting firms had to ensure compliance with the new rules, in case they became owners of defaulting debtor companies and thus responsible for illegal equipment. As you can see from this example, some organisations are directly affected and some indirectly. It is, then, vital for all organisations to know what is going on in their environment. How do each of the environments affect the organisation? We can look at them in turn and see their importance.

Political Environment The political system affects all organisations and determines the context within which business operates. A property owning, free market, democratic system will create an environment within which private business can flourish, while a command economy will prefer State ownership of enterprises and controls on their activities. In the UK it is more likely that a Labour government would favour intervention in industry than a Conservative one. Deregulation and privatisation have created more competition, but privatisation in turn has created a need for regulation and the establishment of bodies like Ofgas and Oftel. Because the government wishes to restrict state intervention in industry, the financial sector regulates itself, whereas in other countries this is done by statutory bodies. Central government and local authorities are major employers – indeed in many towns they are the biggest employers. A change in policy can have major effects on the local economy and on the firms that serve the community. Government is also a major customer of the private sector; changes in defence spending, for example, can have major effects on firms. There are many reasons for government intervention in the economy including the provision of public and merit goods, protecting consumers and employees, holding a balance between employers and unions, and carrying out its economic policies. The national political environment must be seen more and more as part of a wider international system. The European Community often has a political bias which is different from that in the member countries. Britain opted out of the single European currency because the UK government decided it was contrary to British interests, but the debate is ongoing and community politics continue to affect the UK. Pressure groups exist to influence government and politicians, and their activities can also have a major impact on industries and individual firms. Government departments frequently consult pressure groups about new regulations and legislation. Collectively and individually, businesses have to be prepared to deal with the effects of pressure group campaigns. European pressure groups campaign just as much as British ones, which themselves are often involved in European and international activities.

Economic Environment There are two aspects to the economic environment; government economic policy and the market. The government intervenes in the economy in order to carry out a range of policies including:  Control of inflation

 Stimulating growth and employment  Redistribution of income  Regional development  Support for declining industries  Support for research and development There can be major changes in the economic environment as the government pursues its aims. Taxes and interest rates may be raised to try to reduce inflation. This reduces demand by consumers and makes it more expensive for firms to borrow and investment in new equipment is reduced as demand falls. For example, in the late eighties the Chancellor gave notice in the Budget that the rules on mortgage interest tax relief would be changed to restrict the total amount of the mortgage on which it was granted. The result was a house-buying spree as people rushed to take advantage of the old rules; that led in turn to increased demand for carpets and furnishings. In the nineties, the combined effect of higher interest rates and lower tax reliefs was lower demand for houses, and carpet sales in Britain fell by 22% between 1988 and 1992. The market can change because of events abroad. Lower interest rates in the USA to encourage expansion out of a recession, which cause a fall in the value of the dollar relative to the pound, can make it worthwhile for American firms to export to the UK as dollar goods become relatively cheaper. A Danish furniture manufacturer facing a saturated home market may decide to diversify into Britain. So what at first sight may appear to be a very broad and remote economic measure may nevertheless have impacts on individual firms.

Social Environment Changes in social attitudes can affect the market and the firm. Many more women are at work in the year 2000 than in the mid-1970s. This has increased the demand for part-time jobs and has made it easier for firms to cope with fluctuation in work loads. It has increased the demand for one-stop shopping and benefited supermarkets. There is more demand for convenience and take-away foods. Women spend more on work clothes. Social changes affect political and business attitudes to the environment. There is a growing belief that business should be concerned with ethical principles outside such purely business concepts as honesty and fair dealing. The Cadbury Report on corporate governance recommended that all boards should have non-executive directors who would be responsible for setting the pay of senior management. Professional bodies have codes of conduct for their members. Managements are expected to respect the ecological environment. Businesses are expected to play a part in local affairs and this includes contracts with local schools which guarantee jobs to successful students. Companies take part in many school activities and provide work experience placements for thousands of students from schools and colleges.

Technological Environment Technological change has gone on ever since the age of the caveman. It affects products, production facilities and the organisation of work. To take an obvious example, the personal computer has become a commonplace tool in every office and has completely changed methods of recording, storing and retrieving information. It has changed production methods, as designs can be computer-created and tested and scheduling components can be controlled in real time. It has changed leisure as well as work. There is a whole new industry creating computer games, while anyone with a modem has access to a worldwide network of information and people. In the very near future, true three-dimensional computer images will make "virtual reality" into a major leisure and training industry. You will be able to

© ABE and RRC Organisations in their Environment 51 play football in the World Cup final, and surgeons will be able to practice complicated operations without real patients. Technological advances bring improved quality. For example, disease-resistant plants can be produced using genetics. Cell technology makes it possible to replicate a plant thousands of times from a piece of material, so making it possible to introduce improved varieties very quickly. Better plants give heavier yields from the same area and help to protect forests that would otherwise be cut down as population increases.

Ecological Environment Concern about the environment has led to measures to reduce global warming. As well as helping to cut the government's deficit, the imposition of VAT on fuel was required as part of Britain's international obligation to reduce power station emissions. Differential taxation of leaded and unleaded petrol, and of diesel, goes along with the compulsory fitting of catalysts to reduce the harmful effects of car exhausts. This has affected the mix of fuel used in power stations, to the detriment of coal, and created a new market for titanium. Recycling is a major business. Local authorities provide for glass, metal and paper collections. Firms collect large amounts which were simply scrapped at one time. European car manufacturers have agreed standards for car construction which make them virtually 100% recyclable, including difficult materials like plastics. A business can be directly affected by ecological concerns. Thus McDonald's was severely criticised for using polystyrene packaging for its fast food – it was packaging burgers for instant eating in a material with a life of a thousand years. So McDonald's joined with an environmental pressure group to find ways of reducing the ecological impact of its business. As well as trying systems to recycle used polystyrene, which is possible, the company used a different packaging material which could not be recycled but which took up much less space in dumps. It has gone on to examine all aspects of its operation to reduce the effects on the environment. The company has benefited from cost reductions and pleased its customers. Concern for the environment has brought new methods of disposing of waste. What is effectively a big microwave oven can recover rubber, carbon, steel and oil from old tyres, where previously they had to be burned, with bad effects on the atmosphere. Protection of the local ecology has provided nature refuges at oil refineries and airports. Firms recognise that failure to consider the ecological effects of their activities can lead to consumer boycotts of their products.

Legal Environment There are legal constraints on many aspects of an organisation's activities. Examples include:  Employment and redundancy law  Laws against discrimination  Health and safety at work  Laws concerning marketing and sales, including trade descriptions and cooling-off periods for credit agreements  Laws governing labour relations, including strikes and pickets  Regulation of monopolies and restrictive practices. As well as United Kingdom statute and common law, the laws and regulations of the European Community have to be observed. These cover many of the same areas, and British statutes have been amended to align them with the European requirements. A change in European law can open up new markets. For example, in 1999 the EU Working

Time Directive was implemented in the UK, limiting the maximum working hours of employees in accordance with the directive.

B. STAKEHOLDERS

Stakeholder analysis presents a different perspective on the environment of business. Here we are concerned with the immediate relationship between the business and those who have an interest in it. What is crucial to this is what this interest is and what influence the holder of that interest may be able to exert on the organisation. Remember, from Unit 1, that a stakeholder is anyone with an interest in the business. Stakeholders can be individuals, groups of people or organisations. The only thing they may have in common is their interest in the business. The interests themselves are not necessarily financial, but can encompass social, ethical and moral issues as well.

The Interests of Stakeholders The key stakeholders and their interests can be seen as follows.  Owners The owners of a large business will be the shareholders and some of these are likely to be institutional investors from major investment organisations such as pension and insurance funds, investment and unit trusts. These institutional shareholders may well have large blocks of shares and may well take a more active and informed interest in the business than a typical private shareholder might. The key interest for the owners of any business is going to be profit. For shareholders, that is likely to be just as clearly focussed on dividend payments, but they will also have an interest in overall business performance especially as it could affect share prices.  Workforce The workforce encompasses both managers and workers and it has to be recognised that they often have different interests, although usually centred around jobs and pay. At one extreme, there are the directors – a group of individuals, elected by the shareholders, and responsible for formulating overall company objectives and strategies for the business. This is with the interests of the shareholders in mind, so the success or failure of those objectives and strategies will be judged by such indices as share price of the company, profitability, dividend, market share, etc. Their own remuneration will very often be linked to this, reinforcing the requirement to act in the sole pursuit of those objectives and strategies. The directors are accountable to shareholders for the performance of the business and will not wish to provoke any adverse stakeholder reaction which may jeopardise their positions. The directors are supported by a team of managers who are, in general, salaried employees. They are likely to working to specific targets and will have an obvious interest in how successfully these have been achieved. The outcomes will have effects on management job security and promotion prospects as well as employment packages. In general, then, they will have an interest in the success of the business overall, but will be more particularly concerned with objectives closer to their division or section and level of authority and responsibility. Members of the general workforce (and, possibly, their representatives in the form of trade unions) are likely to be primarily interested in jobs and pay – for example, protecting jobs, job security, job satisfaction, improving current pay levels, pensions,

etc. To some extent their ability to do this (and also the ability of their unions) will be linked to the overall success of the business.  Customers Customers are external to the business and their interests reflect this. We would expect them to be concerned with issues such as price, product, quality and customer service levels. Customers may well have an ambivalent attitude to profit, recognising that firms need to make profit but also realising that large profits can result from customer exploitation. There may also be an interest in the continued existence of the business. After all, customers might want to buy again.  Suppliers Suppliers look for lasting business relationships and fair treatment. The continued survival of the business is important in relation to future orders. However, suppliers also have a clear interest in the ability of the business to meet its obligations. Most large businesses have a range of suppliers who have supplied products and services on credit terms. Such creditors need to be assured that payments will be made. This extends to lenders as well who will want guarantees in respect of interest payments and the eventual repayment of the loan.  Competitors In recent years in many industries there has been a growing interest in what the competition is doing. Overall business performance as evidenced by sales, profitability, growth and innovation are important to competitors. It is increasingly common practice for businesses to establish benchmarks based on various performance indicators of other companies, especially companies in the same industry. These are used to help shape strategies and policies.  The community The term "community" can be taken to encompass all those with whom an organisation has a relationship which is not a direct business relationship. This will include local communities in which businesses operate, as well as a range of pressure and interest groups of various kinds which are concerned with the particular type of business or the impact of its activities on the environment in general. In respect of the local community, there will be interest in the overall business performance of organisations as it affects local employment and prosperity. The success of many small local businesses is likely to be linked to the continued presence and success of big local businesses. However, there may be other issues related to the quality of life – such as land use, pollution, traffic flows, etc. – which affect the local community.  The State The State should be taken to include local government as well as central government. The State's immediate interest is in the ability of the business to meet its tax and social security obligations. In the short term, this is a question of cash flows of individual businesses. However, there is also a longer-term interest in relation to the employment levels and the contribution to general prosperity which the businesses in general, and occasionally particular business organisations, could deliver.

Conflicts of Interest There are, then, a range of stakeholders with a range of interests and it takes only a cursory examination to see that, while all have an interest in the success of the organisation, there is plenty of scope for conflicts between the stakeholders. To examine some of these issues we can considers a scenario which is not all that uncommon. A company decides to outsource the supply of a major component – for example, a car producer in the UK may decide to have its car seats manufactured in Eastern Europe instead of at its UK plant. The underlying reasons for the action are likely to be to reduce costs and boost profits – a decision taken by the directors in the interests of the shareholders. But the impact on other stakeholders could be identified:  The workforce are going to see job losses. They may also see that this move could mean further outsourcing in the future, which threatens job security. Middle and junior management staffs may well also face redundancy.  UK suppliers will be possible losers as they see supply contracts ended.  The State will lose out in terms of lost tax and social security contributions and will also face increased spending on unemployment benefits and other social support. There will also be the impact on the country's balance of payments position as imports rise.  The local community will also experience losses as local incomes and spending fall, as well as possible falls in local land values. This will obviously affect retail and leisure operations and there may be further secondary local job losses resulting. It is possible to see that there might be scope for some compromise in this situation. For example, the workforce or the trade unions might offer to accept pay cuts and/or changes to working practices in order to deliver cost savings to the company. Company management might be prepared to postpone the implementation of the policy in an effort to show a willingness to compromise. The state might offer the business some level of subsidy in return for an undertaking not to move the business overseas. The key point here is that in any situation where stakeholder interests conflict, there can be scope for resolving the problem or for some form of compromise. Another dimension to conflicts of interest is that their intensity can change over time and in response to changing circumstances. A significant factor is the impact of the economic business cycle. This cycle affects market economies over time and results in a cycle of recession, recovery, boom and then downturn to the next recession. The general level of activity in the economy is affected – in particular, spending levels, output volumes, employment and profits. As an economy slides into recession after a boom, competition becomes more intense as the same number of businesses compete for a shrinking level of spending. In this environment, conflicts between stakeholder interests will be sharpened as businesses take action to protect sales and profits by a range of policies involving cost cuts and laying off workers. Consumers may appear to benefit from lower prices, but then some consumers may also find their purchasing power reduced by unemployment. Business failure rate will accelerate leaving problems for trade and financial creditors. As recovery leads to boom, conflicts of interest tend to be lessened. In an environment where most firms are experiencing rising sales and improved profit margins, output level are also likely to be rising as well as employment rewards. It is going to much simpler to meet the interests of the various stakeholders. If the cake is getting bigger, it is possible for everyone to have a larger slice.

Stakeholder Influence Up to now, we have considered stakeholders as reactive – they respond to events which affect their interests. In practice, some stakeholder groups tend to take a more proactive approach by trying to influence and shape policies and events in ways which further their interests. We can see this by examining the ways in which stakeholders act in their interests.  Amongst owners, perhaps the key shareholders are large institutional investors, such as investment and unit trusts, pension funds and insurance company life funds. These investors will have very substantial funds to invest and professional fund managers seeking the best possible returns. These fund managers will try to exercise very powerful influence on boards of directors to produce profits and dividends in line with the funds' expectations. These influences can be very strong in shaping business objectives and strategy towards the interests of shareholders. The impact of these policies may be less beneficial to other stakeholders such as workers and consumers.  Financial creditors, particularly the banks, may also seek to influence the ways in which businesses are run. The chief interests of these stakeholders are likely to be interest payments and the eventual repayment of loans. Even if loans are secured on company assets, these creditors would rather see loans repaid by a viable business than secure the money by having to sell off the business's assets. Theses creditors may seek to influence business policy to protect their interests.  The workforce may decide to make their interests more prominent, usually in an organised way operating through trade unions. Trade unions can take a range of actions to promote the interests of their members for improved pay and conditions, for job security. These can include strike action or working to rule, overtime bans and the like. Establishing the interests of the workforce as dominant at a particular time is likely to have an effect on other stakeholders – for example, a business may concede a pay claim if it feels it can pass on the higher costs to customers.  Customers themselves can also exert influence. In general, consumers are much less organised than workers or management and consequently their pressure tends to be less focused. However, customers can exert their interest through what they choose to buy, or not to buy. Where there is a general consumer movement – as in concerns about food quality and growth in demand for organic foods – changes in consumer spending can impact significantly on company profits and force businesses to change policy. This can be seen in the increasing demand for particular levels of quality in the delivery of services or the standards of products. Similar effects can result from straightforward changes in consumer tastes and preferences, and in concerns for the environment (which could affect business in issues as diverse as packaging policy, labelling and control of emissions).  Companies, acting as customers themselves, expect their suppliers to meet stringent quality standards, and this is especially important when just-in-time production methods are used. Firms are aware that their customers judge them on the quality of their products. If a component, supplied by another company, fails, the customer blames the maker, not the supplier of the faulty component. This is why Jaguar instituted a quality programme for its suppliers and worked with them to improve standards. The aim was 100% reliability. Jaguar insisted that if any part failed, no matter how small, the supplier of it would pay all the costs of repair and of providing the customer with a replacement vehicle. Companies like Marks and Spencer have their own quality control inspectors working in their suppliers' factories.  In the public sector, quality standards have often been incorporated in customer charters, and performance is examined to see if standards have been met. For example, the Inland Revenue has guidelines for the maximum times to respond to

taxpayers' queries on different matters and for making refunds of overpaid tax. Railways have standards for punctuality and regularity – if trains do not meet published targets in these areas, customers should be compensated. Not all of these schemes are yet working well, but there is a continuing effort to respond to the interests of customers and raise standards of performance.  Consumers can also exert influence by bringing pressure to bear on the State to enact legislation which furthers their interests such as the Trade Descriptions Act or the Sale of Goods Act. In this way, one group of stakeholders may seek to gain influence through other stakeholders. This can also be seen in the practices of some pressure groups acting on behalf of the environment in seeking to influence both government policy and shareholders.  The State can exercise obvious influence through the tax and spend system or through interest rate or exchange rate policy. These polices have general effects – for example, an increase in interest rates will raise the costs of business in general with an on-going impact on a range of stakeholder interests. In some cases, the effects are more specific in that they affect individual firms and industries – for example, in respect of tax policies on tobacco or oil products.  The influence of government can also be seen in relation to its spending priorities. If the government decides to switch spending from defence to health services, this will have effects on a range of businesses in both industries. We have already seen that the government may also offer subsidies to get a favourable outcome in some cases. Overall, the various stakeholders will seek to use whatever influence they may have to strengthen their interests. It should also be clear that some stakeholders are in a better position to do this than others. There is concern about the primacy of shareholder and director interests, and increasingly, enterprises are judged by their customers and others on their behaviour as much as on price and product. One impact of this is that organisations have developed policies which deal with business ethics. An ethical code of conduct that seeks to prevent directors and other senior managers exploiting their position would cover the following areas.  The duty of managers to take account of the interests of all stakeholders in the organisation, including the general public, as well as to make a profit.  The need to have regard to the safety of workers and users of products.  Avoidance of bribery and corruption and of giving excessively large gifts or generous contract terms, even in countries where these practices are accepted.  The principle that managers should not misuse their authority for personal gain. Directors no longer get long-term service contracts which entitle them to a very large payoff if their contract is terminated before the end of the period; most are moving onto two-year contracts.  The need to respect confidentiality of customer and supplier information.  Making every effort to comply with good business practices such as paying on time according to terms.  Many businesses now adopt policies that attempt to recognise and take account of a much wider range of stakeholder interests. This is often referred to as satisficing (a combination of the words 'satisfy' and 'suffice') and reflects a strategy based on compromise between objectives rather than maximisation of just a narrow range.

C. RESPONDING TO CHANGE IN THE ENVIRONMENT

When there is a change in the PESTEL environment matrix, an organisation has to respond. It may do nothing, in which case it might lose market share or even go out of business. Alternatively, it can change its product or production methods – and this applies just as much to services as to goods – or it can change its structure or revise its policies. Many of the effects of changes in the business environment can be foreseen and allowed for if the firm has systems in place to watch for changes. The enterprise can monitor its own market, keep in close touch with suppliers, and use its trade association to ensure that it is informed about less immediate threats and opportunities. Here we review some of the ways in which business organisations have responded to changes in the political, economic, social and technological environment.

Political Change and its Impact on Business The government has a great influence on business activity. In the first place it dictates the legal framework within which the business must operate and imposes regulations that must be adhered to. These can cover health and safety issues, consumer protection, advertising standards, employment conditions and environmental factors. This can have an impact on the business; for example new laws regarding the labelling and packaging of goods for the added protection of the consumer will usually result in increased costs. However, some changes in regulations might provide new market opportunities. For example a law tightening fire regulations might lead to an increased demand for fire appliances, protective clothing and appliance testing. A new tax on using land-fill sites for disposing of rubbish has resulted in a growth in the recycling business. Governments also influence business through the tax system. Indirect taxes make goods more expensive for the consumer while subsidies reduce the market price and increase demand. Other influences include items such as planning permission, financial incentives regarding location or the promotion of exports. This may influence where a firm locates or who it targets its products at. The government is the largest spender in the economy. In the UK it accounts for over 40% of all spending. Obviously the government can influence business by its decisions on what to spend, where to spend and with which firms.

Economic Change The state of the economy is one of the most important influences. Most economies exhibit a trade cycle of growth and perhaps boom followed by a slow down and possibly recession. This will affect the level of demand for a firm's products. In a recession the general level of demand falls which will limit the ability of the firm to sell its goods at their full price. In the UK the recession of the early 1990s resulted in around 62,000 firms closing in a single year. In a period of recovery or boom the general level of demand rises, which will increase the ability of the firm to sell its goods at profitable prices. It will also provide the opportunity for new firms to emerge. Firms will also be affected by changes in unemployment levels or interest rates. Growing unemployment will reduce demand while rising interest rates will increase business costs. The reverse is true for falling unemployment and cuts in interest rates. In a similar way, changes in the exchange rate will affect the ability of firms to compete against foreign companies in their own markets and to be competitive abroad. Another economic factor is the amount of competition and the behaviour adopted by competitors. For example, a firm may adopt a price cutting policy. This will demand a response from all similar firms in the industry, otherwise they may lose market share.

Social Change A business must be aware of changes in society. Demographic changes will affect demand in different sectors. The ageing population in Europe has led to greater demands for health care and nursing homes. Similarly an economy with an expanding, younger population will experience rising demand for children's clothes, childcare facilities and schools. As societies grow wealthier, the population spends a greater proportion of its money on leisure pursuits such as foreign holidays, sports and pastimes. Changes in public attitudes can also affect a business. The public are more environmentally aware and are not prepared to buy products and services that are considered antisocial, such as aerosols that contain CFCs. Consumer opinion has forced firms to abandon trade involving endangered species and the production of goods that leads to the destruction of the rain forests. Failure to recognise change and to adapt can lead to the decline and eventual closure of a business. Early recognition of these changes can provide opportunities. The Body Shop has expanded globally by marketing its environmentally safe cosmetics.

Technological Change Technological changes can be the most significant external factor. New products, new methods of manufacture and new materials have been developed that have changed the market completely. Word processors have all but eliminated the demand for typewriters. Many products are now made from hardened plastic rather than wood or steel. The use of the microchip has revolutionised the watch industry. The car industry makes full use of robotics in order to eliminate the need for labour and to ensure a higher quality product. Changes like these affect a firm's market and each business must adapt to the opportunities or be left behind by more progressive competitors. Technological changes affect not only the production process but also the range of products that is possible. The microchip has led to the miniaturisation of many products while the development of plastics has revolutionised the style of products and their cost. The media and leisure industries have witnessed vast changes with the advent of miniaturised music systems, flat screen televisions, High Definition broadcasting and advanced computer games. The quality of items has also been affected. In agriculture, science has developed disease-resistant plants, improved crop yields and created new hybrid specimens. A change in technology can have serious positive or negative effects on a business. On the positive side technological change has led to the development of new raw materials that can result in easier manufacturing processes and lower costs. The rapid development of moulded plastics has allowed electrical and automotive products to be made not only cheaper but also in more stylish designs. Technology can also lead to changes in processes. The advent of computers has led to high-speed, fully automated flow production systems being developed. This in turn has led to lower unit costs and lower consumer prices. New technologies have created entirely new markets such as the mobile phone industry and digital broadcasting. On the negative side technology has replaced the need for a lot of unskilled and semi-skilled labour. Those affected have suffered long-term unemployment unless they were fortunate enough to retrain. Advances in science have made some products redundant. Even skill requirements have changed, causing workers to retrain several times in a career. Technological change will also have an extensive impact on employment; this can be summarised as follows:  Very few people can expect to remain in the same job, or even the same industry, for all their working lives. Most people will have to change jobs or change the way they do their jobs several times during a normal working life.

 People must be prepared to retrain and acquire new skills at any time during their working lives. They are likely to find this easier if they have a relatively high level of basic education, particularly in the skills of numeracy and communication. If they do not achieve this before commencing work they may need to do so during their working lives. This has important implications for the education services, which are likely to be asked to provide more and more courses that can be combined with work – courses likely to be making more use of modern information technology.  An increasing amount of work will be performed individually or by people working in small teams (not necessarily in the same location). Older forms of management and supervision will give way to self-management and co-ordination in many cases.  More work will become more challenging and interesting, but less secure. This has many important social implications

D. SERVICES TO BUSINESS

We have seen that all businesses exist in an environment which, as it changes, exerts pressure on businesses to change in response. However, businesses also exist in an environment which supports and assists them in the pursuit of their objectives. All businesses need a range of services from outside. A typical business manufacturing a product or providing a service will have the knowledge and expertise at a technical level to carry this out, but may need a range of outside services to supplement this in-house ability in order to fulfil other obligations or develop and enhance its manufacturing/service provision.

Banking Services Virtually every business will have a bank account and will look to its bank to provide a range of financial services. Many of the major banks have specialist branches which cater for corporate as opposed to personal customers, and by concentrating their business expertise in these branches, they aim to provide a more targeted service. One of the main exceptions to this is HSBC ( the Hong Kong and Shanghai Banking Corporation) which caters for most of its business customers through its normal branch network. The typical range of services that the commercial banks provide are:  Bank accounts Businesses may want a range of accounts including the standard cheque accounts plus reserve accounts and possible currency accounts where the business has an export or import trade.  Funds transfers Businesses need to be able to move funds around and the banks provide a range of facilities including the traditional cheque processing as well as direct debit and standing order facilities. For larger "one off "transactions, there are bankers' drafts or the facility to transfer larger single sums at very short notice. At the international level, the banks provide the SWIFT service to make payments. Increasingly, automated transfers are becoming the norm for all forms of payment, including point-of-sales transactions in shops and the payment of salaries and wages. We should not lose sight of the banks' facilities for accepting payments, including deposits outside normal banking hours.  Financial administration Banks also offer payroll, sales ledger and purchases ledger facilities to business customers to save on administration costs.

 Factoring Most major banks offer invoice factoring services to improve company cash flow. Many businesses sell to other businesses and have to offer trade credit terms. This means that the selling company may have to wait for some months before being paid. In the meantime, the business has to meet its own bills. One solution to this cash flow situation is to enter into a factoring arrangement with a bank. Under this arrangement, the selling company invoices the buying company in the usual way, but also sends a copy to the factor (the bank). On receiving the invoice, the factor pays, typically, 80% of the invoice value by return. In due course, the buying company will pay the invoice (to the factor). At this point, the factor pays the 20% balance to the selling company. The factor charges the selling company client a percentage for the service.  Provision of funds A mainstay of banking is their lending business. The chief lending instruments are overdrafts and loans, and the bank will charge a rate of interest on the amount lent. Overdrafts are simply arrangements which allow account holders to overdraw on their bank balance by up to an agreed limit for an agreed period. The business will usually only pay interest on the amount actually overdrawn, rather than on the full overdraft facility. Banks also offer a wide range of loans for various business purposes such as expansion or new investment. Bank loans involve the bank crediting the customer's account with the full amount of the loan at the beginning. There will be some agreement between the bank and the business on repayment terms. As far as the borrower is concerned, the main issues are likely to be the interest charges and other fees, plus the possible question of security required by the bank. Bank loans are available for periods of between 6 months and 25 years. The interest rate is usually agreed at the start and does not vary throughout the period of the loan.

Other Financial Service Providers Although for many businesses the banks are going to be the chief on-going providers of financial services, there are other institutions which also have significant roles. At this stage, we shall look at the main ones in outline only – a more detailed description can be found later in the course.  Venture capital companies Some businesses find finance a problem because they have innovative products or services – a recent example is the spate of Dot.com Internet businesses which have developed. There are also situations where large businesses want to sell of parts of their operations to an existing management team – a management buy-out. These kinds of venture tend to be high risk and, therefore, not very attractive to most main stream investors. In recent years, a number of venture capital companies have appeared who are prepared to invest in high-risk enterprises either via loans or equity stakes. Venture capitalists will tend to want high potential profits in return for their risk taking.  Merchant banks and investment banks These are essentially wholesale banks who offer a range of services to business including: (a) advice on take over or merger options (b) capital restructuring of businesses (c) underwriting new issues of shares and loan stock

Investment banks may also take over businesses in their own names as investments.  Leasing companies Many businesses may want to lease equipment rather than purchase it outright. Virtually any business asset can be leased, but the most popular are those which require on-going support, such as vehicle fleets and computer systems. There are a large number of leasing companies who will arrange leasing deals for business clients. Some leasing deals have built -options for the lessee to purchase the asset at the end of the lease, a situation known as lease/purchase. Most leasing companies are owned by the banks.  Contract hire Some businesses may decide to hire assets on a fixed-term basis. The main difference from leasing is that the contracting company and not the hirer will be responsible for repairs and maintenance. Contract hire is most frequently seen in relation to company vehicles. Under the contract terms the business agrees to pay monthly/quarterly sums for the use of the asset. This will appear as an overhead in the profit and loss account. One point to bear in mind about both leasing and contract hire is that the assets themselves do not belong to the business using them and will not therefore appear in their balance sheet.

Consultancies A wide range of consultancies have grown up in the last two decades. They offer specialist services – usually of a professional nature – to businesses of all sizes in return for agreed fees. Businesses make extensive use of outside specialists to advise on courses of action where they do not have the necessary skills or expertise themselves. Apart from offering specialist expertise that the organisation does not have in-house, external consultants have a number of advantages. They are likely to take an objective view of the business. They will not be involved in any company in-fighting and have no vested interest in the business. As outsiders, they can bring fresh perspectives and insights which organisation insiders cannot see, and as specialists, they are also likely to be up to date with current theories and ideas. Consultants will also bring valuable experience of other business organisations, which could be very useful. Finally, consultants will also feel themselves to be under pressure to produce high quality outcomes in return for the fees they are collecting. The range of services available is extensive. The main ones, though, are as follows.  Management consultants These are probably the best known of all consultancies. They developed in the US first, but have spread to all major business economies. There are a number of scenarios where management consultants may be used – for example, where the business faces some unusual situation or development, or if conflicts arise within the business which cannot be resolved. These situations range from relatively minor to major issues such as the overall direction of the business, its organisation; its future growth direction, possible joint ventures with other organisations. The list is endless. It is not unknown for management to call in consultants to confirm a decision which has already been taken, but which the company's management prefers to appear to come from an independent outside source – decisions like this will often be bad news for some sections of the business.

 Advertising agencies Businesses often feel the need for expert guidance in relation to advertising, and in particular how to use their advertising budgets to best effect. Advertising agencies offer a range of services to business including planning an advertising campaign, producing the advertisements themselves and booking advertising slots on TV, radio or in other media.  Marketing agencies These organisations carry out a rather broader role for business clients. In essence, this involves producing an entire marketing strategy for a business involving the four Ps – price, product, place and promotion.  Public relations consultants These organisations are concerned primarily with company image and can advise business clients on a range of strategies to develop and enhance that image. They can be of particular help when a business has suffered some sort of crisis and has attracted adverse publicity. The use of a PR consultancy with their expertise in handling the media can make a contribution to overall crisis management.

Government Services to Business Governments in different countries have varying policies. The outline which follows is based on current UK policies and practice. The term "government" can be taken to mean both national government and local authorities. Both types of government offer services to business. At the national level, the main government department responsible for co-ordinating and delivering services to businesses is the Department of Trade and Industry (DTI). The DTI's range of services is primarily provided through the Small Business Service. This is targeted at new and small enterprises and offers a network of advice on issues including:  Business start ups  Finance  Staffing and training  Suppliers and supply chains  Marketing  Computers  Productivity  The EU  Environment The delivery of this service at local level is the responsibility of Learning and Skills Councils (replacing Training and Enterprise Councils) and Business Links. The Leaning and Skills Councils have a particular role in training schemes for business. The Business Links network is intended to provide a "one stop shop" for local business, offering advice and support on any of the issues listed above. The UK is also a major trading nation, and many firms look to the government for advice and support in the area of overseas trade. Trade UK is a DTI organisation set up to provide this service. For exporters it can supply much practical advice by using the expertise of UK government embassies and High Commissions around the world. These diplomatic sources have a vast array of information on local conditions, regulations and so on which can be passed on to UK exporters. In particular, the names of contacts in overseas countries can be

© ABE and RRC Organisations in their Environment 63 provided and the availability of exhibitions and trade fairs made known. Trade UK can also supply potential leads for UK exporters. Local authorities also provide support for business, mainly in the form of creating industrial estates and business parks which provide ready-made units for business with all the major services on site. In many cases, very favourable rents are available to new businesses taking up units. The main incentive for this is that new businesses provide local employment and increase the income of the local authorities themselves.

E. LOCATION OF INDUSTRY

The final aspect of this review of the environment of business organisations is their location.

Factors Determining Location When a firm decides on a location for its activities it makes the decision on the basis of costs and benefits. Each possibility is weighed up according to the costs which include land and buildings, power supply, labour and training, transport and communication with suppliers and customers, and compliance with environmental protection. The benefits of each alternative include the availability of a trained labour force, a support system of specialist firms providing industry-specific training, information services and design facilities, green field sites where the company can set up exactly as it wishes and the availability of government grants.

The market

Land Ancillary industry

Raw THE FIRM Power supplies material

Government Communications support Labour

Figure 4.1: The Influences on Location of Industry

The relative pull of each component of the decision depends on its importance to the firm.  Sometimes the availability of power supplies is of over-riding importance. Aluminium is rarely made where bauxite, its raw material, is mined. Cheap power is of so great importance that the bauxite is transported half way across the world to countries like Norway and Sweden, which have huge amounts of cheap hydro-electric power.  In another industry it is proximity to the market which matters most of all. Furniture is bulky, fragile, and difficult to transport without damage. The manufacturers therefore set up as close as possible to the major cities while still being reasonably close to their raw material. The forests around High Wycombe made it an ideal location close to London. Warehousing and distribution firms tend to set up where motorways meet or where there are good transhipment points between road and rail.

 Access to a skilled labour force may be the most important factor. This is what brings firms to the so-called Silicon Valley between Slough and Reading in England, Silicon Glen in Central Scotland and the original Silicon Valley in California. Each of these areas has a concentration of universities and colleges turning out technologically trained graduates. Over the years this has built up a pool of labour with the right training and skills for computer firms. Co-operation with the research facilities of the universities is an added advantage.  Lack of specific skills may be the most important criterion. When an industry has a history of poor labour relations and bad working practices, firms seek out a completely new location to get away from the problems of the past. This is why Japanese car component and assembly plants are found in Wales and North East England well away from the established centres of the industry. Improved transport facilities mean that it is no longer essential to be near suppliers or customers. The availability of green field sites was an added advantage as the firms could design and build exactly what they wanted and have room for future expansion.  The availability of raw materials often determines a firm's location. Coal mines can only be sited where there is coal, mineral water companies where there is a suitable spring, brick manufacturers where there is the right sort of clay. The extraction industries have limited location options. However, these are not all renewable resources and eventually they become exhausted. This is what happened to the iron mines in Britain. Local ore was replaced with imports. Steel works gradually moved to the coast because of the cost of transport over land of heavy, low-value material. Technology also played its part as new methods of steel-making meant that the cost of production could be significantly reduced by keeping the product hot all the way through the process. Integrated steel mills replaced a system where iron ore was turned into blocks, moved elsewhere to be turned into steel, then on to another plant to be rolled into sheet.  Land costs and availability are important to some industries. There are fewer than thirty possible locations for a new airport in Britain, and very few more potential sites for a new oil refinery. Land is an important part of building costs; in many cases industrial development is competing with agriculture. Large flat areas attract developers. Where land area is restricted, the answer is to build upwards as in New York. But this is expensive and can only be justified for high value-added activities; which is why the financial district has skyscrapers.  History also plays its part. Once an industry is established in a certain location it attracts all kinds of support from specialist information services to communication systems. Collectively these are known as external economies of scale. As an industry grows bigger all firms, regardless of their individual size, benefit from the reduction in their unit costs which results from this accumulation of ancillary industry to serve the needs of companies in the main industry. Thus banking and financial organisations cluster together in the City of London. Access to their markets brought them together – banks set up in Lombard Street in the seventeenth century to be near their merchant customers. More firms were attracted as the financial markets developed; specialists set up to serve their needs; accepting and discount houses to deal in bills of exchange soon appeared. Nearness to the Bank of England and the other banks was important for getting information quickly and staying in touch with customers. Information services grew to meet demands for up-to- date market prices, foreign affairs and shipping news. Dealing facilities were set up, like the Stock Exchange for stocks and shares, Lloyds for insurance, and the commodities exchanges. The foreign exchange market has its own dedicated telephone system linking banks worldwide at the touch of a computer screen. This intense concentration of financial activity has brought the development of a huge

diversity of ancillary firms – specialist solicitors, printers, security transport, recruitment, training, computers, building, catering, investigation and many other businesses exist to serve the financial community in the City.  The City is also a good example of how changing technology has affected location. Twenty years ago firms had to have a large headquarters staff to process, manage and retrieve documents. This could mean heavy head-office costs to house a lot of comparatively junior and low-paid workers; they, further, incurred high added costs of travel, which were paid for in the form of London allowances and interest-free loans. Electronic data processing with document storage and retrieval means that nowadays all of these routine tasks can be done at another location. This is why so many insurance companies have relocated part of their head office work to places like Bournemouth. Office costs per square foot there are a tenth of those in the City, staff costs are lower and efficiency does not suffer, as information can be accessed on-line from London. A small office is maintained in the City to provide contacts with other financial institutions and markets and commercial clients. The cost of housing the necessary senior management in a City of London office can be justified.  In making a relocation decision the organisation has to consider the staff cost very carefully. Key members have to be persuaded to move. The costs of recruitment and training for new workers have to be set against the costs of relocating existing personnel. The help of specialist firms is usually enlisted to find a suitable range of housing, show groups of staff around the new area, organise removals and help people settle in. Over the years firms have become much less dependent on raw materials and energy sources. Electricity had replaced coal as the source of industrial power by the late 1960s. New products and new manufacturing methods have meant that many industrial companies have become footloose – they are not tied to any specific location. The low weight and bulk of their components make them cheap to transport. The final product, like computers and video cameras, has very high added-value and low bulk, which makes it worthwhile to transport it long distances. Commercial firms can set up certain activities anywhere there are suitable communications facilities. Some part of the business still has to be near the market, though, as in the case of insurance firms. And not all commercial enterprises can be footloose: for example, national advertising agencies locate in London to be near their corporate customers.

Government Influence on Location The location of the firm may be significantly influenced by government policy. The UK government provides various forms of assistance to firms setting up in the Development Areas. Since August 1993 the eligible areas have been restricted mainly to the older industrial areas of Manchester, Liverpool, Glasgow, South Wales, North-East and South- West England, and the North and West of Scotland; Northern Ireland receives special assistance. Firms in these areas can receive grants for capital investment and small firms can get a wide range of help with investment, training and consultancy advice. The European Community provides additional funding for projects in the assisted areas, and has a number of schemes which provide assistance to firms in areas affected by the decline of traditional industries like shipbuilding and coal. Under the EC rules there are limits to the sums a government can spend on attracting foreign investment but there can still be very valuable grants and concessions; the British government has used these to bring in firms like Honda and Toyota. All of these measures can exert a powerful pull on a firm wishing to locate in a new area.

Environmental Change and Location Two trends have emerged over the last twenty years concerning the location of business activity and both have important implications for the organisational structure of the firm. (a) Location by function Large firms have been accustomed to operating from many different sites for a long period. The basis for these different establishments tended to be partly historical – merged or taken-over firms remained in their current sites unless and until there was good reason to relocate – and partly to take advantage of locational advantages for production where these existed. The general pattern has been for each distinct subsidiary or division to retain its administrative functions at its main production site, with central administrative work carried out at a separate head office, usually located in London or another major commercial city. The significant change that has been taking place has been to locate as much as possible of the administrative work, with or without central managerial staff, at a single site, in an area with good communications to London and the major cities but sufficiently distant from these for the company to gain reduced land and labour costs. With computer-based administration, linked by computer and modern telecommunications such as e-mail, the administrative centre of the organisation can be located anywhere that costs are relatively low and where there is access to the main national transport networks of rail, motorway and, increasingly, air. Once the significance of this kind of development becomes more widely recognised we can expect to see further relocation of other functions such as production and marketing, influenced more by contemporary locational advantages and less by accidents of historical development. (b) Home-based work If groups of workers can be linked by telecommunications so, too, can individuals and their place of work or, more accurately, their work centre or centres. A growing number of people are now working from home doing work arranged and paid for by one or more firms. This process is now often termed telecommuting. It is at its most advanced in computer software production, where software houses can operate an international marketing service, arranging what to produce and then organising the production of the software by commissioning individuals or teams of software writers. The writers organise the actual production themselves, within the time constraints established by their commissioning organisation. This kind of organisation, made possible by modern information technology, is remarkably similar to the organisational structure on which the first emerging modern industry – the woollen industry – was based. The software house is the equivalent of the 18th century merchant who linked the producers to the market and organised the production chain. The software writers are the equivalent of the spinners and weavers who actually made the woollen cloth. Notice that the actual maker of the product under this latest version of the outwork system has regained control over the production process. The writer can choose when and how much to work provided, of course, there is sufficient demand for the writer's work. As in the 18th century, those reputed to produce the best work and able to meet contract times are generally offered more work than they can cope with, while those with less favourable reputations tend to struggle to earn a steady living. No other industry appears to have gone as far along this organisational cycle as software production but others are making some moves in this direction. Book production relies heavily on editors and designers and fewer of these now go to work in the publisher's offices. More work at home, often for several publishers. It is difficult to

think of any industry where at least some of its production could not be performed by people working at home. Notice that the latest technological revolution is having a twofold effect on the production process. On the one hand it makes it possible for many specialised, non- routine activities to be carried out by individuals in their own homes. At the same time, it also makes it possible for much large-scale, repetitive work to be carried out by automated machinery, cared for by very few workers. Most of these will effectively be dial watchers, trained to spot anything not operating correctly and to take action to limit the damage caused by malfunction and breakdown. They will also contact those able to repair and replace failed equipment. These emergency service engineers are most likely to be operating from home but with communication equipment enabling them to keep in constant touch with a base which has the task of co-ordinating their work and ensuring that firms with service contracts are provided for efficiently. The employing organisation in this kind of production system becomes essentially a co- ordinating body. Management in such a body is still concerned with taking decisions under conditions of uncertainty but the nature of the decisions is changing. In the factory-based system production is largely concerned with control and discipline. There is a stock of equipment and labour which has to be adapted to the production requirements that senior management has opted for in co-operation with the marketing and purchasing functions. Adaptation, modification and, from time to time, changes in both equipment and labour are often difficult, time-consuming and costly processes. Labour is frequently more troublesome and costly to change than capital (equipment). The new style organisation is likely to have fewer constraints imposed by a fixed stock of equipment and labour. Managerial success is more likely to depend on knowledge, e.g. knowing what and where equipment and labour are available, what their capabilities are and what the cost of various operations is likely to be. The knowledge must, of course, be applied and this involves co- ordination and, in many cases, persuasion. Many different operations, taking place in many different locations, will have to be brought together to satisfy the requirements of the ultimate consumer. Computer packages will help in storing, sifting and co-ordinating the information needed by managers, but a great deal of human judgment will also be required, not least because decisions will still have to be made now to meet conditions which the manager believes will be applying in the future. One of the constant features of management throughout the ages remains the element of uncertainty about the future.

Study Unit 5 Growth and Scale of Business Organisations

Contents Page

Introduction 70

A. Growth Strategies 71 Integration and Diversification 71 Ansoff's Product/Market Growth Strategies 72

B. How Do Organisations Grow? 73 Organic Growth 73 Growth by Acquisition 75 Demergers 76

C. Economies of Scale 77 Internal Economies of Large-Scale Production 78

D. Diseconomies of Scale 79 Internal Diseconomies 79 Survival of Small Firms 80

E. Globalisation 81 Globalisation and Locational Factors 81 Globalisation and the Product Life Cycle 83 The Growth of Multinational Companies 84 Foreign Investment and Internalisation 86

INTRODUCTION

Firms wish to grow for many reasons, not the least of them being the driving ambition of an entrepreneur. Organisations often grow as they develop new products and markets. Sometimes this growth is defensive, i.e. necessary because saturation has been reached in one market or because a product has reached the end of its profitable life. Success in the original activity or in innovation is often the means to growth for an organisation of whatever type. Organisations may grow organically through the development of their existing business or activity, or growth may be external through mergers and takeovers. Both methods have their advantages and disadvantages. Whichever way an enterprise expands, it will enjoy advantages and face problems. The major benefits of growth come from the economies of large-scale production, which reduce cost per unit, and the advantages of large organisations which give power in the market; on the other hand too much expansion can lead to diseconomies of scale. Just as the individual firm can experience economies and diseconomies of scale as it grows, so too a whole industry can benefit or suffer as it develops. One of the major developments in organisational growth and the scale of operations has been globalisation. Markets and the location of business operations are being seen less and less as local or even national. Increasingly, the whole world is available to even medium- sized companies and, with the advent of e-commerce and global communications, to small businesses, including sole traders. Objectives When you have completed this study unit you will be able to:  Outline the reasons for the growth of organisations.  Describe the types of internal (organic) and external growth, including mergers and takeovers.  Explain the reasons for integration and diversification.  Describe the internal economies of scale and explain their effects on the costs of the firm.  Describe the diseconomies of scale and explain their effects on the enterprise.  Explain the reasons for demergers.  Discuss the reasons for the survival of small firms.  Explain the move towards the globalisation of business.

A. GROWTH STRATEGIES

Most private sector service organisations pursue growth in one form or another, whether as an explicit aim of the organisation or an implicit aim of its managers. You should be able to recognise different types of growth patterns and their implications for a business.

Integration and Diversification An organisation can grow by extending its operations to other stages of the chain of production or by expanding its operations at a similar point in the chain:  Horizontal integration is where a firm expands its interests at the same stage in the production chain.  Vertical integration may involve moves backwards towards the raw materials or forwards to the consumer. When a firm moves into new markets or products, the process is called diversification. The processes involved are shown diagrammatically in Figure 5.1.

Figure 5.1: Integration and Diversification

Horizontal integration may be brought about where two firms producing much the same product come together. The takeover of Volvo Cars by Ford is an example. The advantages expected are immediate increases in market share and production capacity. It may also give defensive benefits by keeping out a rival firm or closing excess production capacity which affects all companies' profitability. Lateral integration is similar but the firms involved are in different sectors of the same market – for example, a chocolate manufacturer joining with a maker of boiled sweets or a car assembler merging with a truck producer. The expected advantages are the same and one sector of the overall market may be growing faster than another. Backward vertical integration may be undertaken to safeguard supplies; so Ford owns firms making spark plugs and car seats. It gives the producer greater control over deliveries. The immediate reason may be a fear that a rival company will get priority at a time of shortages. Forward vertical integration moves the firm towards its customers. Clothes manufacturers, for instance, may take over chains of shops. It gives the company control of its market outlets. Integration can bring economies by cutting out excess stock holdings and through a better flow of information about market changes. Diversification, as we have said, is when a firm moves into new markets or products. It may be a deliberate move to counter the problems of a declining market or to take advantage of opportunities for expansion, for example the banks taking over estate agents. It may result from an integration merger with a firm which has a range of products. Or the production process itself may give the opportunity; for example washing-up liquid started as a by- product of oil refining for which the company tried to find a use. Sometimes a new market is opened up because the firm has excess capacity. For example, banks require massive computing power for daytime on-line work, but at night it can be set to run payroll calculations for customers. Local authorities have set up similar operations. Finally a new market could be found for an existing product – cable television has added telephone communications and started moving into retailing by offering a TV shopping catalogue with telephone links to suppliers.

Ansoff's Product/Market Growth Strategies A further insight into organisations' growth strategies is provided by Ansoff's Product/Market expansion grid. It is a simple framework which holds that an organisation's growth can be analysed in terms of two key development dimensions – markets and products. For each dimension, growth may be based on the existing situation or a new product/market. Figure 5.2 illustrates the possibilities.

Product Existing New g n i

t MARKET PRODUCT s i

x PENETRATION DEVELOPMENT t E e k r a M

w MARKET

e DIVERSIFICATION

N DEVELOPMENT

Figure 5.2: Ansoff Matrix

The grid consequently identifies four development options, each associated with differing sets of problems and opportunities for organisations. These relate to the level of resources required to implement a particular strategy, and the level of risk associated with each. It follows, therefore, that what might be a feasible growth strategy for one organisation may not be for another. These are the four generic growth options:  Market penetration strategy This focuses growth on the existing product range by encouraging higher levels of take-up of a service among the existing target markets (e.g. a supplier of fresh orange juice encouraging its customers to drink orange juice on occasions when they might otherwise consume another type of drink).  Market development strategy This strategy builds upon the existing product range which an organisation has established, but seeks to find new groups of customers for it. In this way mobile telephone companies in the UK have extended their basic product offering to additional groups, including students and lower income groups who previously would not have considered buying a mobile phone.  Product development strategy As an alternative to selling existing products into new markets, an organisation may choose to develop new products for its existing markets. Again referring to mobile phones, many companies have developed innovative products to offer as additional accessories to existing customers, including "hands-free" car kits, traffic information services and on-line information services.  Diversification strategy Here, an organisation expands by developing new products for new markets. Diversification can take a number of forms. The company could stay within the same general product/market area, but diversify into a new point of the distribution chain – for example, a mobile phone network operator may move into operating its own retail shops. Alternatively, it could branch out into completely new areas, such as radio and television broadcasting. In practice, most growth that occurs is a combination of product development and market development. You should be able to evaluate any proposed growth strategy in terms of the resources that it will consume, the strengths and weaknesses of the company relative to the proposed strategy and the level of risk that it entails.

B. HOW DO ORGANISATIONS GROW?

There are basically two options for growth – internal or organic growth and growth by acquisition – although many organisations grow by a combination of the two processes. The manner of growth has important marketing implications, for instance in the speed with which an organisation can expand into new market opportunities.

Organic Growth This is considered to be the more "natural" pattern of growth for an organisation. The initial investment by the organisation results in profits, an established customer base and well established technical, personnel and financial resources. This provides a foundation for future growth. In this sense, success breeds success, for the rate of the organisation's growth is influenced by the extent to which it has succeeded in building up internally the means for future expansion.

Many retail chains have grown organically by developing one region before moving on to another. In the UK, Sainsbury's grew organically from its southern base towards the northern regions, while Asda grew organically during the 1970s and early 1980s from its northern base towards the south. Organic growth alone sets limits on the speed at which an organisation can grow. The firm may be in a very slow growing market, making organic growth difficult. Companies with relatively high capital requirements will find organic growth relatively slow. Many firms start small but continue to grow because they gain a growing share of an expanding market. A sole trader, for instance, can develop a new product and keep on growing as the product is developed to meet the demands of the market. As the firm expands, new capital is required. The bank will fund expansion through loans and give an overdraft for working capital. Security is required, and this is likely to be limited by the amount of land and property owned by the proprietor. Further expansion may require a partner, who may bring capital and a different kind of expertise into the firm. For example, many personal computer firms started off as one-man businesses run by a technical innovator: a partner with marketing expertise would be a valuable addition. Further partners could be brought in to add to capital and specialise in different areas. There are often advertisements in the financial press for partners who can bring customers with them to financial services firms. The alternative to a partnership is to form a private limited company. As we have seen, there are additional advantages to a company over a partnership, especially limited liability. A private company can raise finance from a number of investors either by issuing shares or through debentures. An entrepreneur who wants to keep control can retain 51% of the equity and raise capital by issuing the rest. Venture capitalists provide finance to firms with potential. They are looking for a stake in firms with growth prospects. When the business has reached a sufficient stage of development and profitability, the venture capitalist recoups the investment and makes a profit by bringing the company to the capital market through a quote as a public company on the Stock Exchange. Most of the banks and some of the insurance companies have a venture capital arm. There are also private individuals who will invest in firms with good prospects. A public limited company can raise finance from many more sources than any other type of organisation. It can be flexible in its financing to meet the requirements of different types of investors. Suppose that a firm wants to develop a new gold mine; this is a high-risk venture which will not show any returns for a long time, until the mine is sunk and gold is processed and sold. A lot of capital is required for the hole in the ground, which may prove worthless, and for machinery to crush the rock and extract gold at the rate of two ounces per ton of ore. This could be financed by issuing a convertible debenture, which pays a guaranteed return throughout the development phase and can be converted to equities when gold is being processed. The investors then share in any extra profits, for example if there is more gold per ton than forecast. An established company seeking finance for growth can make a rights issue at a discount to existing shareholders. This preserves their control of the business and gives them the opportunity to benefit from the expansion. A shareholder offered the right to buy two new shares for every five held may not, of course, wish to take up the offer, in which case he or she can sell the right to someone else. Large firms can raise money on the Euromarkets. A Eurobond is a loan certificate denominated in the currency of a country different from that of the issuing firm. Thus it may be particularly advantageous for a British company wanting to expand in America to raise

© ABE and RRC Growth and Scale of Business Organisations 75 money through a dollar Eurobond. A consortium of international banks will organise the issue and sell the bonds to investors in several countries except that of the currency. Shorter-term finance, but which can be "rolled over" – renewed for additional periods – can be raised in the Eurocurrency market in several leading currencies including dollars, sterling, French francs, deutschmarks and Japanese yen. A Eurocurrency is any currency held in bank accounts outside its country of origin. Eurodollars are exactly the same as dollars in a bank in the USA, but they are in accounts in other countries all over the world.

Growth by Acquisition External growth is quicker than internal or organic growth. It involves acquisitions through mergers and takeovers.  A merger is where two firms amalgamate their capital and their operations. They form a new company, often through a holding company.  A takeover is where one firm buys a controlling share in another. It may offer its own shares or a mixture of shares and cash. Stock Exchange rules require that shareholders are always offered a cash alternative. Mergers and takeovers have the advantages of speed and, possibly, being cheaper than building production capacity from scratch. The value of the acquired firm may raise the price of the new entity's shares on the market, giving an immediate benefit to shareholders. A contested takeover may bid up the price of the target firm beyond this point, as rival companies improve their offers to tempt shareholders to sell. A particular reason for an acquisition is that it gives quick entry into a new market. The firm has the benefits of existing suppliers, customers and management. Alternatively the company may seek to gain control of its supplies or its outlets. This method may often appear more attractive. In some cases it may be almost essential in order to achieve economies of scale to operate profitably and efficiently – for example, many UK DIY retail chains have grown by acquisition in order to achieve a critical mass, so that they can pass on lower prices resulting from economies in buying, distribution and promotion. Many small chains have not been able to grow organically at a sufficient rate to achieve this size, resulting in their takeover or merger to form larger chains. Growth by acquisition may occur where an organisation sees its existing market sector contracting and it seeks to diversify into other areas. The time and risk associated with starting a new venture in a strange market sector may be considered too great. Acquiring an established business could be less risky, allowing access to an established client base and technical skills. Synergy effects are expected to result in lower costs. These come from the idea that the result of the merger will be a firm which is more efficient than the previous two were separately. There can be more specialisation and operations can be rationalised – for example, the salesforce can sell more of the same kind of products to the same range of customers, credit controllers probably deal with the same customers, the accounts department can simply add any new business to the computer, staff savings can be made through redundancies, and production and property can be rationalised and the surplus sold off. Conglomerates are holding companies which have subsidiaries in a wide range of unrelated industries. This philosophy is that successful management of any firm requires the same skills. Their objective is to seek out underperforming enterprises and, by applying superior management, turn them into profitable companies. This may involve selling off unwanted parts, rationalisation and reorganisation into divisions of the conglomerate. The size of the undertaking and the value of its assets make it possible for a conglomerate to raise finance for acquisitions. There is always the benefit that when firms in one industry are doing badly, those in another may be doing well.

Demergers As firms become larger they begin to suffer inefficiencies; we shall look at this shortly in the section on diseconomies of scale. Stock exchange investors lose faith in the ability of directors to manage a wide range of activities. The firm may be unable to pursue profitable opportunities because of lack of finance and management having to spend too much time on underperforming subsidiaries. The firm may have grown by acquisitions which have taken it into activities and markets of only marginal benefit. The answer is to demerge these unwanted operations and concentrate on the core businesses which generate profits. Demerged operations can be sold to another company which is in that line of business. They can alternatively be sold to their managers who, free of the constraints of belonging to a large, diversified group, may well be able to achieve greater success. A management buy-out occurs when the managers and workers buy their own firm, as occurred with numerous subsidiaries of the National Bus Company, which were bought by consortia that included employees. The volume and value of management buy-outs and buy-ins is closely related to the business cycle. Many firms have sold unwanted subsidiaries to their management. (A management buy-in occurs when managers buy control of a company they have not previously worked for.) There are many reasons that lead to management buy-outs. Sometimes a company has gone into receivership and a buy-out is seen as one way of protecting jobs. Moreover, employees have an inside understanding of how a business works and may be more willing to buy into it than an outside investor. On other occasions, a business unit may no longer fit with a company's strategy and sale to a management team may offer the quickest and best value option to the company for selling the unit. Companies frequently keep a stake in businesses which they sell. They can benefit from any growth and the new enterprise is not overburdened with debt. Thorn-EMI decided to concentrate on music, audiovisual equipment and TV rental: it therefore sold a number of non-core businesses in which it kept a stake including Thorn Lighting, Thorn-EMI Software and Kenwood, the maker of small electric kitchen appliances, while in the meantime it was acquiring Chrysalis and Virgin Music. In other cases, the selling firm parts with the whole stake in order to raise as much as possible to invest in the core business or to add acquisitions to it. Volvo, after its failed merger attempt with Renault, decided to concentrate on its vehicles, engine and construction equipment businesses. It sold its stake in an investment company to another Swedish investment specialist which, in turn, sold some of its holdings including control of a health- care firm. The experience of diversified groups has been that success comes from concentrating their scarce management resources on those areas where they can do well and which fit their aims. Remember that takeovers and mergers can bring in all sorts of activities to a large group. For example, when Boots bought Ward White, another chemist retail chain, it also got Fads, the paint and wallpaper chain. It makes management and economic sense to sell off these activities to strengthen the core.

C. ECONOMIES OF SCALE

Economies of scale refer to the savings made in terms of the cost of producing each unit of production as a result of increasing size. In order to understand this completely, we need to consider how the costs of an organisation are made up. Firms produce by combining the factors of production – land, capital and labour. There is a cost involved in using these factors. The average cost per unit of production is made up of two types of cost:  fixed costs, which do not vary with output, like rent and property insurance;  variable costs, which do vary with changes in production, like wages and raw material. In the short run, the firm has to work with at least one factor being fixed in quantity. For example, a factory has only so much building space or machinery – if demand increases, although labour can be increased through overtime or increasing the workforce, the number of machines remains the same and it is not possible to build more warehousing. Therefore, in the short run, firms must operate at a given scale of production. Within this, as production increases, the total average cost per unit will at first fall as the fixed costs are spread over more production. After a certain point, though, the rise in variable costs caused by paying more wages and repairing overworked machinery will outweigh the effect of the falling fixed cost, and average total cost per unit will rise. This is shown in Figure 5.3.

Cost per 700 Unit 600

500

400 Average Total Cost 300

200 Average Variable Cost 100 Average Fixed Cost 0 0 100 200 300 400 500 600 700 800 Units produced Figure 5.3: Short-Run Costs

If demand continues to increase and the price covers cost, the firm will go on producing more. Eventually it will pay the firm to move to a new scale of production by adding more of all the factors of production, including any previously in fixed supply. At this new scale of operating, there will once more be a fixed factor which limits the expansion of output. The firm will go through the same process of falling and then rising average total cost. The move to a new scale of production gives the firm the opportunity to gain the economies of large scale, so average total cost will be lower than before. So long as the market continues to expand, the firm can increase its scale of operation. After it reaches the point of lowest

Internal Economies of Large-Scale Production Firms in most industries will have the u-shaped curve shown in Figure 5.2. Increasing the scale of plant gives rise to economies because of the fact that all costs do not increase in proportion to output. Large plants enjoy technical economies which small production plants cannot. (a) Technical economies A large plant can carry specialisation of labour and machinery further than a small one. Labour can then be more efficient and less time is wasted in changing tools. It becomes worthwhile to invest in job-specific equipment; every worker on a car assembly line, say, can have power spanners set to the right torque for each nut instead of having to change the setting for every one. Capital investment in larger machinery does not mean a doubling of cost. A pipeline which has twice the volume of a smaller one does not require twice as much steel. When the Suez Canal was closed, supertankers of 200,000 tons were built to carry oil from the Gulf right round Africa to Europe. They were able to do this at half the cost per barrel of oil compared to a 75,000-ton tanker which could go through the canal. The amount of steel is not proportionally greater to enclose the greater volume; engines do not have to be more powerful to move the ship at a given speed; it becomes worthwhile to automate more of the work so that a smaller crew is required, and the bigger ship can be equipped with oil pumping facilities so that it can load and unload independently of the dockside equipment. There are, however, limits to increasing unit size. Eventually it becomes too costly to pump a bigger volume of oil. Very large tankers can only use a few ports, so that transhipment costs rise. Electricity generation comes up against the problem of increasing transmission costs as power stations increase output beyond a certain point. The optimum size varies for different pieces of capital equipment at various stages of production. Keeping them fully occupied means having a balance between processes; increases in output makes this easier. If, for example, production at stage one requires three machines to each make 12 components per hour to feed one machine at stage two which is capable of processing 30 units, six units of capacity are not utilised. Increased output could mean five machines at stage one producing 60, which would balance with two machines at stage two. This is a problem wherever there is a minimum size for an essential piece of equipment, and why firms try to sell excess capacity to outside users. As output expands other costs do not increase proportionately; for example the stock of machine spares does not increase, nor does the store of spare parts for repairs. A large output makes the firm a valuable-enough customer for suppliers to dedicate production lines to their specification, which improves quality. Increasingly there are direct on-line computer links between suppliers and producers, so that delays in supply are eliminated and production is not interrupted. Technical economies are very important, but there are firms which gain very large economies of scale without having a large plant. Detergent manufacturers are an example: the optimum size of production plant is quite small, so a firm like Unilever can operate a large number of small production units and get enormous economies of scale in other ways. We can, then, point to several other advantages of size.

(b) Managerial economies Managerial economies result from being able to employ more specialists and support them with advanced computer systems and better training. The large firm can attract better qualified staff.

(c) Financial economies Financial economies make it cheaper to raise money. Finance raised by selling shares to the public is likely to cost half as much as a private placing of shares with investing institutions, but is only feasible for large issues. Large firms can go direct to the money markets and get lower interest rates by borrowing large sums. (d) Marketing economies Marketing economies reduce the unit cost of sales. It does not cost much more to sell a large amount than a smaller one. More potential customers can be reached by using television advertising at a lower cost per head, even though the total cost may be much higher than spending on other media by smaller firms. (e) Buying economies Buying economies arise from the quantity discounts offered to large customers. These usually reflect the savings from not having to split up bulk production and repackage it, or the benefits from a long production run without the cost of resetting machinery. Quality control can be tighter, with less waste through having to return faulty parts. (f) Risk-bearing economies Risk-bearing economies result from diversification. Production spread over several plants is less likely to suffer disruption from strikes, accidents or disasters. The bigger the share of the market which is held, the sooner new trends in demand should be identified. A firm making many products sold in different markets is less likely to suffer from changes in demand: it will have time to overcome difficulties which might harm a single-plant or single-product firm.

D. DISECONOMIES OF SCALE

Internal Diseconomies The growing firm is unlikely to suffer from technical diseconomies of scale. There are physical limits to the extent of these economies, as we have seen. The costs of the firm will increase after it has grown beyond the optimum size because of the disadvantages of large organisations; the firm's average cost will then start to rise. Note that the firm can go on producing well beyond its optimal scale so long as price covers cost. Even if the price remains fixed it pays the firm to go on adding capacity; all that happens is that profit per unit decreases. The major reason for the increase in costs is management diseconomies. These include:  Communication difficulties caused by longer chains of command  Delays in responding to market changes because of the need to consult and slow decision-making processes  Bureaucracy, which results in excessive administration costs  Poor morale and motivation as people feel that they do not have a stake in the firm  Information overload for managers, who cannot absorb enough detail to make informed decisions.

Large firms can become such important users of labour and facilities that they create shortages and drive up wages and prices against themselves. With a large workforce, trade unions may be able to exert strong influence to achieve wage increases. Managers in market-dominating firms grant higher wages easily, and accept overmanning, because the costs can be passed on to consumers. Specialisation means that a small number of workers become key personnel who are able to disrupt production – as, for example, with the banks' mainframe computer operators.

Survival of Small Firms Most firms in industrialised economies are small, employing fewer than a hundred people, and the great majority fewer than ten. Large enterprises exist in those industries where there is a significant economy of scale to be had. This may be technical, as in electricity generation which requires large plants; or it may be that there are significant marketing or buying economies, as in the case of supermarket chains, where the individual plant (the shop itself) is relatively small. The risk-bearing economies may be vital, as in banking, where a network of small branches operates to gather up a large-quantity of money in small amounts to put it to use in diversified loans. But even where there are significant technical economies and advantages of size, there are invariably small firms in the same industry. There are various possible reasons why small firms can and do survive.  Many industries do not require the use of much equipment, so the technical economies are limited and large firms do not have any significant advantage. There are few economies of scale in window cleaning or hairdressing, for example, so the average size of firms in these sectors is low.  The size of the market is limited. It may be localised, for example house repairs and alterations, so jobbing builders are small firms.  Personal service is important, and this limits the extent of the market. There are no significant advantages of size so large chains do not appear. Hairdressers and solicitors are examples.  There are frequent changes in the market, for example due to fashion; so the flexibility and speed of response of small firms makes them more successful than large ones. This applies in the boutique clothing industry.  Small firms often fill niches left by large ones which do not want to take on small-scale specialist work. Car makers like Morgan and Reliant serve markets of no interest to companies like Ford and Fiat.  Individual skills may be of prime importance, for example in the craft industries. The sole proprietor in this kind of industry often benefits from collective marketing at craft fairs and through craft associations.  People want to be their own bosses and set up enterprises where this is possible. Often little capital is required, as in writing software for computer games, yet very large incomes can sometimes be earned. There are many instances where small firms can flourish because they get access to facilities and services which give them the advantages of economies of scale. Small printing firms can send completed books to specialist binders which have large-capacity machinery. Industry associations, universities and government laboratories offer research and development opportunities to small firms. Collective marketing and buying provide advantages, for example in farmers' co-operatives. The individual who wants to set up in business with as many advantages of size as possible can turn to a franchise operator. The franchiser will provide a business plan, specialist

© ABE and RRC Growth and Scale of Business Organisations 81 equipment and marketing support; financial help and assistance in finding premises are usually available. The franchisee is guaranteed a local market. There are many franchises on every high street including McDonalds, The Body Shop, photo processing and dry cleaning firms. There are also industrial franchises. As production technology changes towards more and more assembly of components, and as people want more individual products, small firms are likely to flourish just as much in manufacturing as they do in services and retailing.

E. GLOBALISATION

Since the Second World War the world of economically independent nations has become increasingly a global economy of interconnected and interdependent communities. What happens to the economy of Manchester depends more and more on what is going on in other continents rather than on the pattern of change in the British economy. One result of this globalisation of the economy is that production is becoming internationalised. Fewer and fewer industries are oriented towards purely local or national markets. Those firms which produce for their region are not immune from the effects of global change. They do not have export markets to be affected by a shift in exchange rates, but the movement in the rate may make it worthwhile for a foreign competitor to enter their home market. Few firms or industries have any protection from international trade. Government monopolies still enjoy protection in some areas like telephone communications; but their defences are constantly being eroded by technological advances and international agreements. The EC has proposals for opening up all national telecommunication systems in the common market to competition. Satellite communications systems make it impossible for governments to control broadcasts. Developments in portable telephones will soon make terrestrial cable connections unnecessary. Only non-tradable goods, like haircuts, will be immune from foreign competition.

Globalisation and Locational Factors Advances in transport and communications have made it possible for firms to set up anywhere. This has meant that international industrial location is affected by the same factors as determine the location of firms nationally – for example:  Availability of power supplies  Availability of labour  Access to markets  Access to raw materials and land  Existence of ancillary industry giving external economies of scale  Government policy. A specific reason which does not apply at home for a business to invest in a foreign subsidiary is to gain access to the market where there are barriers to imports. (a) Factor availability and cost In the case of the extractive industries, the dominating feature is the presence of the desired natural resource. There is no point drilling an oil well where there is no oil. The more valuable the resource, the greater the willingness to take risks and incur expense to obtain it. Oil companies have overcome some of the most inhospitable environments to win oil. Industries such as oil, where capital (equipment) costs are heavy compared with labour, and where raw material availability dominates location, may have to import

most or even all their labour needs at a cost per worker that would be prohibitive for a manufacturing company. However, labour availability and cost are significant for most forms of production and the greater the ratio of labour to total cost, the greater will be the attraction of areas which can offer low labour costs and freedom from costly restrictive and productivity damaging labour practices. Manufacturing companies, therefore, find Third World countries attractive for their low wage rates. However, there are costs counterbalancing this. Labour costs depend on the productivity obtained from workers as well as the wages paid to them. Productivity depends on an effectively trained, supervised and motivated workforce. This can involve heavy costs in importing expatriate managerial and technical workers (at least in the first instance) and in training and supervising unskilled workers to ensure that low wages are not counterbalanced by high material wastage and supervision costs. There can be high hidden costs in maintaining an expatriate workforce, including the loss of good workers through family inability to cope with a strange culture or climate and the consequences of expatriates offending local customs and cultures. (Local hostility to what is regarded as the offensive behaviour and lifestyles of expatriates is a major problem in certain areas of the world, particularly in Islamic countries.) (b) Trading blocs In spite of the high ideals and the institutions set up over the years to promote free trade and the removal of tariffs and other trade barriers (such as the World Trade Organization), the world has retained a significant level of trade protection. Indeed, the origin of the European Union as the "Common Market" can be seen as a very powerful trade protection bloc. Other important groupings include the North American Free Trade Agreement (NAFTA) of Canada, USA and Mexico and the Association of Southeast Asian Nations (ASEAN). One way in which a large company from outside can "climb over the protective wall" of the bloc is to become established in one of the member countries and often the simplest way to do this is to take over a company within that country. If takeover is not possible, or not desirable, another possibility is to form a joint venture with a domestic organisation. The multinational contributes technical skill, managerial know-how and access to world markets and sources of supply and sometimes capital; the home company contributes local knowledge, access to the home market and can frequently provide low cost production factors of high potential quality. The desire to penetrate the EU market and to overcome import prejudice has been a major factor in persuading the Japanese to drop their preference for the home production and exporting option. To preserve stronger managerial control they have sometimes preferred to establish new production units instead of taking over existing firms. (c) Government policies Most governments have, at various times, sought to develop new industries by offering financial incentives to attract business investment. They have also pursued strong regional policies designed to persuade companies to locate in areas of relatively high unemployment and to dissuade them from exercising their preference to expand in existing growth regions. In the UK, for example, incentives were offered for investment in areas other than London, the South-East and Midlands. It is also the case that different governments pursue different social and labour policies, some of which are perceived to be unfriendly to business interests. Faced with a range of different incentives and disincentives, not unnaturally, companies will prefer to concentrate new investment in countries where production promises to be more profitable. Thus, foreign companies seeking to secure a base within the EU have taken advantage of financial concessions available for locating in certain regions in the

United Kingdom. Others have invested in countries where there are few restrictions on labour practices or on production – so developing countries have benefited from inward investment (although not, perhaps, from safe operating practices and high wages). Europe and North America are seen as areas of high taxation, and companies have found they could reduce their total tax liabilities by switching production to countries with more accommodating tax policies. Changes in production technology have meant that more and more products are assembled rather than being made in one place from the raw material onwards. The various parts are made in several different countries according to where the location factors are most favourable. Computers are a good example: silicon chips for the operating system are made in the USA, keyboards assembled in Taiwan, memory chips made in Japan, power supply units assembled in China, disk drives in Singapore or Scotland, monitors in Thailand and the whole lot brought together and assembled in the country where they are to be sold. Deskilling of jobs has made it easier to move production to where labour costs are lowest. For example, the keyboards for IBM computers are assembled by robots which pick and place the letters and numbers. The operator simply has to put the right ones in the correct hopper.

Globalisation and the Product Life Cycle This recognises that the influence of locational factors changes as the product passes through its own life cycle. The product life cycle is assumed to start with a period of introduction and slow growth for the product. If successful, sales grow more rapidly until the market becomes saturated and growth slows and sales levels stabilise to form a plateau and then at some point they decline as the product is replaced by others. The stages in the cycle are widely accepted but, of course, the time periods involved for the stages can vary enormously for different products. The product life cycle, in its application internationally, distinguishes between the domestic and foreign markets and helps to account for the locational decisions made by the major multinational companies. This aspect of the concept was originally developed in relation to American companies which transferred production from America to Europe. It assumes that a product is developed within an advanced country. At the initial stage, it is suggested, with no success guaranteed for the product, it is likely to be produced in the home country for the home market. It is desirable for producers to be in close contact with the market so that any necessary modifications can be made. At this stage the product is unlikely to be price sensitive as the suppliers will enjoy the benefits of innovative monopoly. Success in the domestic market brings three developments:  opportunities appear in those foreign markets which are closest to the domestic one;  large-scale production enables the producers to standardise the product as the potential gains from further modification diminish; and  imitators appear, to expose the product to more severe price competition. As production facilities come to require renewal, the prospect of relocating within the newer, still-growing markets becomes more attractive and the company is likely to invest in the newer markets, reduce production costs and supply its home markets from its newer production plants abroad. Over the course of the cycle exports turn into imports and the company extends its production activities to foreign markets. This view of the product life cycle is illustrated diagrammatically in Figure 5.4.

Figure 5.4: The Product Cycle

The new product is developed in an advanced country and consumed in that country. It is also exported to markets in less advanced countries. As the market declines in the advanced country but expands in less advanced countries, production is switched to the less advanced areas which then export to meet market demand in the advanced country. Since the major companies are multi-product producers, this process is likely to be taking place over several product areas at the same time with products at different stages of their life cycles.

The Growth of Multinational Companies Multinational companies have played a very large part in the spread of industry around the globe, and a high proportion of international trade is dominated by the production and location decisions of the major multinational companies. These reflect the companies' perception of their own best profit interests as they seek out the lowest production cost location for each stage of the production process. Manufacturing is regionalised, with various parts being made in several countries. The European car industry is an example with Ford, General Motors, Renault and others making components in different countries and bringing them together for final assembly – Figure 5.5 illustrates a typical arrangement. For the multinational this has the advantage of flexibility. Output is not interrupted by a strike or a fire as the parts are brought from elsewhere. Changes in demand can be met with relative ease. Just-in-time methods of manufacture, where components are delivered direct to the production line from the supplier instead of being held in stock, have made this sort of flexibility essential. A significant proportion of trade is, in fact, the transfer of manufacturing components and services within the multinational companies themselves, i.e. intra-company transfer. In 1980 semi-manufactured goods represented 28% of British exports and 26% of British imports. Much of this trade in semi-manufactures related to the intra-firm transfers within multinational companies.

Figure 5.5: The European Construction of a "British" Toyota Carina assembled at Burnaston, England

The trend to globalisation of manufacturing is likely to accelerate. Commerce and services will follow. In some cases the trend is well established. Banking makes use of off-shore centres where tax concessions and disclosure requirements make international operations attractive. The Channel Islands, the Isle of Man and the Cayman Islands are very small countries with important banking and financial centres. The globalisation of world markets has important implications for both the host and the home countries. For developed host countries the effects are frequently beneficial in revitalising industries whose relative stagnation may have offered rich opportunities for the global enterprise willing to enter the market. For developing countries the consequences are less certain and depend on the extent to which genuine technology transfer takes place. Multinational development in some countries can distort social and economic progress and give rise to severe social and political problems. In the home country the global enterprise is sometimes accused of exporting jobs to low factor cost countries and there is some truth in this. On the other hand, as we have noted earlier, the pattern of world production is shifting and the ability of Western multinational companies to move into newly industrialising countries helps to keep them in business and their profits provide incomes for Western shareholders who might otherwise see the value of their capital disappear as domestic companies fail to survive in the new, competitive world markets. The conclusion seems to be that multinational enterprises do have a huge potential for bringing benefits to nations. By transferring technology and spreading management and technical skills they can speed up world development and raise living standards. They can actually change the value of resources within nations and, consequently, the pattern of advantage between nations. They can thus influence the direction of trade flows. This

© ABE and RRC 86 Growth and Scale of Business Organisations power, like all other forms of power, has dangers. There is always the temptation for dominant producers to hold back national development in order to preserve low-cost resources. There is the temptation to interfere in national politics in order to gain or preserve special privileges or keep competitors out of particular markets. The problem, then, is how to maximise the benefits and minimise the dangers while recognising that the primary duty of any commercial enterprise in a market economy is to foster the interests of its shareholders subject to the social obligations it owes to its employees and the human and physical environment within which it operates.

Foreign Investment and Internalisation If a foreign producer decides to concentrate production at home and export to its foreign markets, it will be obliged to market through agents and import houses and license any necessary service and maintenance work to firms in the local markets. Inevitably the producer will have to pass on much of its knowledge and expertise to local firms and in doing so sacrifice the knowledge advantage which is the source of its profit and justification for its extension of the market. To avoid this sacrifice the foreign producer is likely to keep direct control over production and marketing in the local market thus keeping its knowledge advantage as a major asset. This suggests that a significant reason for direct foreign investment is the desire to internalise, i.e. retain within the organisation its profit-generating superior knowledge and general know-how. The belief that internalisation is a powerful motive for multinational business enterprise conflicts with the benefits to host countries often claimed by leaders of the large multinationals for their worldwide activities. One of the most important benefits claimed is the transfer of technology and the sharing of knowledge. This claim has been eloquently expressed by the Chairman of Shell who pointed out that Shell had made deliberate efforts to train managers from all the host countries up to very high levels so that skills and knowledge would be shared by all participating countries. At the same time it is only fair to point out that technology in the oil industry is highly specialised and dependent on the massive capital investment that is very much controlled from the centre of the oil multinationals. Consequently the host countries obtain only limited benefits from this specialised form of technology transfer outside the tightly controlled international oil industry. Technology transfer and the extent of internalised control over knowledge are difficult to measure so while it is impossible to say that there is indisputable support for the concept of internalisation, it is also likely that there is some truth in it for some aspects of multinational development, such as the expansion of American manufacturing in Europe. It is a much less likely explanation of the more recent expansion of Japanese investment in Europe and America. In this case you could argue that a powerful motive for Japanese direct investment and the export of Japanese management associated with it, once the decision to produce outside Japan had been taken, was conviction in the superiority of Japanese production methods and management and a determination not to allow these to be diluted by the transfer of production location. It has also been argued, in a slight extension of the internalisation concept, that multinationals maintain control over production in order to ensure that they reap the full rewards of their superior technology.

Study Unit 6 The Production Function

Contents Page

Introduction 88

A. Production Systems and Techniques 89 Types of Production System 89 Techniques of Production 89 Innovation, Research and Development 92

B. Control 92 Policies and Procedures 92 Monitoring and Control 93 Setting Standards 94 Measuring Performance 96 Simple (Closed Loop) and Complex (Open Loop) Control Systems 97

C. Stocks 97 Traditional Approach to Stock 97 The Cost of Stock 98 Just-in-Time (JIT) Systems 99

D. Quality 101 Basic Principles of Quality 101 Managing Quality 103 Total Quality Management 104 Quality Circles (QCs) 106 Quality Back-Up 107

INTRODUCTION

The functional role of the production department is to ensure the effective and efficient creation of goods and services. Some management experts (notably Peters and Drucker) stress the primacy of marketing over all other management functions. However, others see production as the cornerstone of the organisation. This has given rise to two points of view on the orientation of organisations which we can summarise as follows. Note that both have important implications for the production function.  Production orientation This is where organisations give top priority to production and its role in designing, developing and producing a given product. Having set up the means of producing goods, the firm sets out to sell them. The rationale behind this approach is that if a firm is expert at producing something, it is confident that customers will be impressed by its quality, design, and value for money. This approach emphasises the processes of production and we start our examination of the production function by looking at the systems used in such processes.  Customer orientation Firms which stress the importance of the market and what the customers say they want are customer-orientated. They stress the marketing process. They set out to discover what customers want, using market research and product research. When they have found out what types of goods or services customers want, what sort of price customers are prepared to pay, how customers would like the goods packaged, where customers would like to go to buy, etc. they then set about producing them. In customer-orientated firms, the customer comes first and production is tailored to meet their wants. This is called "listening to what the market is telling the firm". Writers like Tom Peters argue that modern organisations should keep the focus on the customer and should aim to get the best and swiftest information on what the market is saying. Customer attention is not something that arises of itself, it must be fostered by management – every customer requirement should be seen as of vital importance. We shall examine the details of marketing in the next unit, but here we can see the implications of this approach in the attention to quality within the production function. Objectives When you have completed this study unit you will be able to:  Distinguish between different types of production system.  Describe the main approaches underlying techniques of production.  Describe the process of innovation, research and development.  Define the objectives of control and assess the role of policies and procedures in its achievement.  Explain the processes involved in control systems.  Discuss approaches to the holding of stock, including just-in-time production systems.  Identify the principles underlying quality systems.  Explain the process involved in quality systems.

A. PRODUCTION SYSTEMS AND TECHNIQUES

Types of Production System The normal way of classifying production systems is under four broad headings as follows.  Job production This type of production system is concerned with making a (usually) high-priced product to an order which is not likely to be repeated, i.e. a one-off job. This calls for skilled workers, who can be flexible in adapting their skills to producing just what the customer requires. A crucial consideration in job production is the fact that nearly all the production costs fall to the one job. Since they cannot be spread over a long run of production, the fixing of a correct selling price is very important.  Batch production This is the production of a given quantity of goods – a number of units of a similar specification. There may be repeat orders for these goods but there is no continuous flow of production. Batch production resembles job production in that these are specialist goods made to fit customers' requirements, but differs in that the costs of production can be spread over a number of units, so allowing firms more scope to invest in new machinery. An example of batch production might be aircraft engines for a given type of aeroplane.  Mass production This is the continuous output of uniform, standardised products for a mass market which offers a regular, continuous demand. The goods are relatively low-priced and are produced by the use of machines and semi-skilled and unskilled labour. A sub-type of mass production is flow production. This makes use of its machines and labour in a sequence called a production line. Cars for the mass market are produced by materials and parts moving along an assembly line until eventually a finished car rolls off at the end. Flow production can take many of the features of mass production and apply them to the manufacture of relatively high-cost goods like cars, washing machines and TV sets.  Process production This refers to the process used to extract products such as oil and gas. It makes possible a continuous flow of production, using expensive machinery, highly automated methods and a mass marketing technique. In mass production, flow production and process production, a small range of products is produced in very large quantities; large capital investment is involved and a mass market is needed to absorb the goods produced. The type of production system will have implications for the way in which a production department is structured. Contingency theorists like Woodward see the type of production system as an important influence on the way in which the whole organisation is structured.

Techniques of Production There are a number of established techniques of production. We consider here some general themes and trends.  Automation and cybernetics Automation offers firms numerous advantages. Production lines can be run continuously, there is less need for inspection, manpower can be reduced and hence productivity is increased. However, automation is costly to introduce and there are

costs in training workers for the new system. As automation has progressed there has been some conflict with workers, who see their existing skills being made redundant. Cybernetics is sometimes described as the basis of automation in that it is concerned with the ways in which computers can replace the functions of the human brain (just as mechanisation is concerned with the way machines replace the functions of the human body). Thus, mechanisation plus cybernetics equals automation, which has advanced into robotics.  Ergonomics This approach sets out to achieve the best possible relationship between workers and their environment. As automation develops, this relationship changes with mechanisation taking over the physical energy input and cybernetic systems taking over the control functions. Ergonomics is important so that the right conditions of heating, light and work layout are available for the performance of the workers' functions.  Computer Aided Design and Manufacture Production departments are making ever-growing use of Computer Aided Design and Computer Assisted Manufacture (CAD/CAM) to develop flexible manufacturing systems. As the name implies, this technique embraces the design, inspection and quality control of goods being produced. It goes beyond automation by bringing into use cost-effective computers to link together design, production and quality control functions. CAD/CAM can be extended to include the final packaging and sending out of goods to customers. CAD/CAM offers a number of benefits: (a) The linking of the various production functions and steps allows for immediate access to evaluate the state of production at a given time, thus assisting effective control. (b) There is less likelihood of breakdown or errors of communication between the various stages of design, production, inspection and despatch of goods. (c) In major projects, integrated sophisticated computer systems have been developed with CAD/CAM as a subsystem of the network. Clients and major suppliers are linked with compatible systems which supply up-to-date information on supplies, stores, design, design changes, progress and costs. The data is monitored to identify changes to the critical path analysis or a budget overrun.  Smoothing the flow of production A number of techniques can be used to keep the flow of production running smoothly – they set out to avoid hold-ups due to shortages of components. (a) Production engineering – This term refers to the design and selection of machines and the layout of production in the best way so that it progresses smoothly. (b) Just-in-time techniques – In order to achieve continuous production there has to be synchronisation between the supply of components and their use or assembly. Holding large stocks of components ties up capital and is costly. Just- in-time techniques set out to integrate the use of components by a manufacturer with the production of these items by suppliers, so that neither carries surplus stocks. (We consider this in more detail later.) (c) Mathematical and statistical techniques which aim to achieve a balance between supply and usage – including exponential smoothing which identifies long-term demand trends by stripping out short-term fluctuations and economic order

quantity (EOQ) which sets the reorder level for stock items so that replacements are ordered at the appropriate time. (d) Lean production – A series of management techniques intended to make more efficient use of limited resources, thereby limiting waste. Techniques might include kaizen, just-in-time and benchmarking in order to maximise productivity while at the same time minimising the resources used. Lean production requires multi-skilled workers who are committed to producing high quality at all times. Lean production produces to order rather than for stock. Demand "pulls" products through the system with the minimum of storage or waiting. This has been used very effectively by car manufacturers and companies such as Dell computers. (e) Cell production – The production system is divided into independent teams or "cells", each of which is responsible for a group of goods or a major part of the manufacturing process. Teams are given devolved responsibility and control over their area. This helps to improve motivation and productivity.  Integrating production systems with customer needs Advances in information technology have enabled many producers to adopt a more proactive approach to production. Examples can be found in the production of both physical goods and provision of services: (a) Car production Historically, cars are produced on assembly lines with a range of versions for each model. So, the BMW 5 Series can be bought with a 1.8 litre engine or a 2.5 litre engine or with added extras, the costs of which are added to the price. Some manufacturers price the product on an "all-in" basis, using the "free extras" incentive. Either way, the customer has a limited degree of flexibility in composition of the car of his or her choice. Manufacturers are now linking the ordering system to the production system. A customer adviser can meet the prospective customer and agree on all the features required – colour, number of doors, size of engine, electronic windows and so on. The specification can be fed into a personal computer on the spot which is linked to the production function, enabling the factory to produce a bespoke vehicle, rather than accepting one from the existing range or having extras added by the dealership. This process is not quite "just-in-time" manufacture – the customer still cannot obtain what he or she wants on the spot. There is, however, a much greater freedom of choice in the purchase. (b) Financial products The traditional approach to marketing financial products was to develop a range of investment and lending services and offer these to customers at a set price. Financial institutions can now approach this the other way around. Take, for example, the personal mortgage product. Ten years ago the customer could choose from repayment method or endowment method. Now the product can be tailored to suit personal financial needs. If the customer wishes to link his or her repayment in with a unit-linked policy or a pension, it can be done. If he or she wants a fixed rate for an initial period, the institution can provide a cost (rate of interest) for the appropriate period. Again, technology is the driver here. Whilst financial institutions historically costed their products on a margin between funding and lending rates, on-line treasury systems can now assist the lender to price funds according to customer

requirements. Similarly, peripheral products such as insurances can be priced on an on-line basis.

Innovation, Research and Development All business organisations need, at some time, to invest in product development – whether it is in improving the existing product or producing new products.  Innovation Innovation provides a bridge between the two key functions of marketing and production. Innovation is an umbrella term which covers both research and development. The key features of innovation are: (a) Generating new ideas and concepts of design, technology or production practices (b) Applying new ideas to creating new products (c) Applying new ideas to improving existing products (d) Initiating quality improvements to products (e) The improvement and development of existing technology and processes of production (f) The introduction of new technology and processes of production.  Research This refers to fundamental work, not necessarily associated with any particular product but dealing with pure scientific principles. Research is often involved in the search for new materials. In highly technical industries, such as aircraft and atomic energy, and in chemicals or medical supplies, research is a very important function. In many industries, outside sources are used for research – e.g. consultants, independent research associations, trade research associations, universities.  Development Development is the application of research to specific products. For example, when fundamental research had discovered new metals capable of withstanding high temperatures, development techniques applied this knowledge to the creation of jet engines. But development techniques are also used extensively throughout industry to improve and modify existing products, and this is their major function.

B. CONTROL

Production management includes responsibility for the control of the production process. Progress management ensures the smooth running of production in the organisation. Materials control ensures that materials of the right specifications are available in the right quantities to facilitate production. Computers are widely used in production planning and control. Cost control is another crucial function of production management. The control functions of an organisation take as their starting point the plans made for that organisation. The framework of control is made up of policies, procedures and rules.

Policies and Procedures Policies are general guides for conduct and decision-making. The essence of policies is that they allow some discretion – they reflect the spirit rather than the letter of ideas on how the organisation may be run. For example, the policy of an organisation may be to ensure customer satisfaction, but the statement of policy does not specify exactly how this is to be achieved.

Procedures are sets of rules as to how activities should be carried out. A procedure is a logical sequence of actions – things which people must do. The relationship between policies and procedures can be seen if we consider an organisation which has a policy of customer satisfaction – it will, therefore, have set procedures to cope with issues like customer complaints.  Advantages of procedures When procedures are established, managerial discretion is severely reduced. Specific steps are clearly set out and these have to be followed to the letter. The main advantages of establishing strict procedures are: (a) Consistency of actions from different people regardless of variations in individual circumstances. (b) Ensuring conformity with laws, for example on health and safety or labour issues such as discrimination and redundancy/dismissal. (c) Ensuring that people pursue the same objectives. (d) Simplification of managerial functions – many people find it easier and safer to follow set procedures and the possibility of inconsistent decisions is much reduced. (e) Decisions can be made without having to refer to senior managerial levels, thus speeding up the decision-making process and preserving the authority of the lower-level manager.  Disadvantages of procedures The disadvantages include: (a) Possible reduction in managerial morale: the more enterprising managers prefer to be allowed to exercise discretion and show their initiative and dislike being governed by detailed rules. (b) Management is in danger of becoming administration. People with enterprise and initiative will not work for an organisation with a reputation of stifling initiative. Managerial standards fall and the organisation becomes ossified and resistant to change. (c) Procedures initially established over a limited area to ensure compliance with the law may start to spread throughout the organisation and to the detriment of effective management. (d) There is a danger that procedures may not be changed when the conditions that led to their introduction change. Some may become irrelevant and be ignored, causing confusion among managers. (e) Both the direct costs of operating procedures and the indirect costs of damage to managerial competence may be higher than any benefits they bring. Like all other managerial techniques, procedures have to be carefully controlled and monitored. Any technique, taken to extremes, can be damaging to the organisation.

Monitoring and Control We have seen how it is necessary for organisations to produce detailed plans expressed in objective terms so that all managers have clear statements of what they are expected to achieve. We have also seen that planning, however detailed, is useless unless it is implemented. Plans also need constantly to be reviewed, and the active review process is termed control. Implicit in the overall concept of control is the requirement to monitor.

The term "monitor" means to maintain regular surveillance over something or someone. Control refers to the checking and identification of performance. In management terms we are concerned that control systems do more than simply check and identify – they should also alert the appropriate manager in time for remedial action. Control may be defined generally as the process by which the organisation ensures that the plans which have been made for its operations are being effectively carried out. More detailed definitions are: "Control consists of verifying whether everything occurs in conformity with the plan adopted, the instructions issued and principles established" (Henri Fayol). "... the function whereby every manager, from President to foreman, makes sure that what is done is what is intended" (Koontz and O'Donnell). In The Practice of Management, Peter Drucker stresses the role of measurement in the control process: "The manager establishes measuring yardsticks – and there are few factors as important to the performance of the organisation and of every man in it. He sees to it that each man in the organisation has measurements available to him which are focused on the performance of the whole organisation, and which at the same time focus on the work of the individual and help him to do it. He analyses performance, appraises it and interprets it. And again, as in every other area of his work, he communicates both the meaning of the measurements and their findings to his subordinates as well as to his superiors."  The control process The basic steps of the control process are: (a) Planning – management have to establish the standards of performance which must be met if the organisation is to achieve its objectives. They must plan for the ways in which progress is to be measured and monitored, the degrees of deviation from standards which will be tolerated and what actions will be taken to correct failures to achieve required performance. (b) Measurement – actual performance must be measured in precise terms. (c) Comparison – actual performance measurements must be compared against standards. (d) Tackling deviations – when deviations from the standards expected by management are detected, appropriate corrective action must be taken.  The role of monitoring As applied to organisations regular surveillance aims to ensure that goods and services are delivered on time to customers and clients. Monitoring is conducted on the exception principle; that is, only items running outside pre-established standards are investigated. The intention is to instigate action that will both deal with the current situation and avoid similar situations arising in the future. In order for the exception principle to work effectively there has to be a flow of up-to-date information, addressed to the appropriate managers.

Setting Standards When managements come to set standards, they first have to decide which are the areas and activities of an organisation that need to be controlled.

 Key results areas Drucker pinpointed the activities which are crucial to the success of a firm and called these "key results areas": (a) Productivity – the number of goods or services produced from a given input of resources. This is a crucial area for the success of an organisation so must be carefully monitored and controlled. (b) Innovation – the source of new ideas. This should be monitored for progress if the organisation is to avoid stagnation. (c) Resources – the financial, physical and human resources of an organisation must be planned and controlled. (d) Management performance – the performance of managers must be monitored to see that it meets the requirements of the organisation. (e) Worker performance – the control system must ensure that workers are performing to the standards set. (f) Market performance – management must ensure that the organisation is meeting the standards required of it by its customers. (g) Public responsibility – the organisation must ensure certain standards of conduct so that it can meet its responsibilities to the community; these must be put in precise terms. (h) Profitability – profits are the lifeblood of businesses so must be monitored closely.  Types of standard Next, managements must decide what type of standard they will put into place. Whenever possible these will be measurable. Standards may be of the following types: (a) Physical – for example, number of items produced or sold, ton-miles of freight carried, durability of a fabric, absentee rate (of labour). (b) Cost – for example, monetary, machine/hour cost, direct and indirect cost per unit produced. (c) Capital standards – for example, ratio of net profits to investment or return on investment. (d) Revenue standards – for example, revenue per bus passenger/mile, average sale per customer. (e) Intangible standards – it is sometimes argued that qualitative standards, for example the goodwill of a business or the morale of a workforce, are difficult to measure, but modern techniques set out to bring these into measurable terms.  Methods of selecting standards There are three main methods for selecting standards: (a) Statistical data – standards are calculated from information of what was achieved in the past. However, allowance has to be made for improved technology or training, which will allow new, higher standards to be set. (b) Appraisal – standards are set by what managers (drawing on experience and judgment) decide is appropriate.

(c) Engineered standards – these are based on objective analysis of the performance which should be achieved in a given situation, e.g. what a worker with given equipment should produce in a set time. Management will select the method of fixing standards which is most appropriate for the type of performance being measured.

Measuring Performance In organisation theory, the elements which record and measure performance are known as sensors. Sensors may be machines which check production or people employed as controllers of quality or output. Accurate recording and measurement are crucial for the operation of the control system. Sensors need to be able to spot deviations from standards or to feed back information to the control unit so that it may compare the data with the standard. Difficulties in measuring performance can be considerable: (a) Closeness and frequency of control need careful consideration. With the current emphasis on individual freedom and dignity, people resent close supervision, so ultimately motivation is liable to suffer. (b) Further, much control information can be misinterpreted or misleading. Of course it should not be, if it is well designed, but human frailty has to be taken into account. (c) A third factor is the danger of an "information overload". Management can be deluged by a mass of facts and figures. One way of coping with this is by employing the technique of management by exception (MBE). This is a filter mechanism which ensures that only those facts and figures which differ from the set standards are referred to the top. While everything goes along normally, there is no need for management action. Where matters are not going according to plan, managers will be alerted so that corrective action can be taken.  Tolerance limits When we compare actual performance with planned standard performance, a relatively small deviation may not be crucially important. The standard itself may allow for minor deviations: if this is the case we talk of tolerance limits. Tolerance limits usually have an upper and a lower level, within which performance is allowed to fluctuate; only when performance breaches the limits is control activated to change performance. The advantage of using tolerance limits is that it reduces the intervention of the control unit; so long as the deviations do not have serious consequences for the organisation it is as well for control not to intervene. The width of the tolerance band will depend on the circumstances, e.g. in precision engineering the allowable deviation from standard will be very small indeed, whereas in other tasks in an organisation there may be considerable leeway allowed for deviation from standard performance. It is also possible to set different tolerance limits depending on the situation. An experienced manager may be allowed greater tolerance, for example, than one new in post who is likely to need the support and guidance of a superior more frequently.  Taking corrective action If performance is as expected, the only action called for is supportive – a good performance deserves praise. Managers must be very careful not to use MBE as a trigger only for criticism. Where performance differs from standard then either steps must be taken to correct performance, or the standards must be examined; if found to be unattainable, they may have to be revised. This step in the process will depend on correct decisions being made by the control unit. This in turn will depend on accurate and relevant information and a high quality of interpretation and analysis.

The new, revised performance then feeds back information to the control unit. If performance now reaches the required standard, no further action is needed. If performance and standards still diverge, further action must be taken.

Simple (Closed Loop) and Complex (Open Loop) Control Systems  Simple (closed loop) systems This type of control simply measures the change in performance from the required standard and acts to correct it. For example, the thermostat in a heating system senses if the temperature has gone above the required setting and, if it has, it cuts off the power and so maintains the required temperature. However, it does not identify the cause of the deviation from standard – it merely corrects no matter what the cause.  Complex (open loop) This type of control goes beyond measurement and correction and analyses the causes of the deviation. In complex organisations there are many combinations of factors which may be affecting performance and making it deviate from standard. Open loop control systems are designed to analyse and discover just what elements are causing the deviation. They operate by changing some elements and then receiving feedback to inform them whether performance has now improved. The technique here is one of experiment until the cause is found, and then action is taken to correct the elements found to be causing the deviation.

C. STOCKS

Most organisations carry stock of some sort even if it only consists of toner for the computer printer and some printer paper. For a manufacturing business or a retail or wholesale organisation, stockholding is a much more significant matter. In a typical manufacturing business, stock will consist of:  Raw materials, fuels and components  Work in progress  Finished stocks The business buys in raw materials, fuels and components from outside suppliers. Once processing has started, they will be converted into work in progress – i.e. products in the course of being manufactured but not yet completed. Finally, when the product has been fully processed, it will be put into finished goods stocks.

Traditional Approach to Stock With traditional production systems, goods are produced for stock and customer orders are met, immediately, from that stock. Stock acts as a cushion between production and sales. This approach means that production can be held at a constant rate with stocks taking the strain if sales vary – for example, for seasonal reasons. An example might help to clarify the situation. A garden furniture producer has a seasonal pattern to its sales, but holds production at a constant level throughout the year, as follows.

Time period Production Stocks Sales units units units

40 (at start of the year)

Quarter 1: Winter 120 55 105

Quarter 2: Spring 120 35 140

Quarter 3: Summer 120 20 135

Quarter 4: Autumn 120 40 100

In this example, production is held at a constant rate of 120 units per quarter. Sales vary seasonally and the stock level acts as cushion. So, in winter, output is 120 units while sales are only 105 units, leading to stock level rising by 15 to 55 units. In spring, however, production is still 120 but sales have risen to 140 units. The business can manage the sales surge by drawing on its stocks to supplement current production (and stocks fall to 35 units). The 40 units of stock at the end of the year will be the opening stock for the next cycle. The advantages of the system are not difficult to see:  Production is constant and, therefore, predictable leading to much easier planning of materials sourcing, and operating schedules and maintenance schedules.  The workforce can be constant, making for easier manpower planning and regular employment, and work shifts are regular – for example, a constant 40-hour week is possible with no need for overtime rates.  It may also mean carrying less production capacity and a more efficient utilisation of capacity. In the example above, if the firm wanted to synchronise production and sales, it would need to be able to produce 140 units in certain quarters, rather than the current 120 units. However, with a capacity of 140 units, the plant would be under- utilised for the rest of the year.  Stocks are useful for meeting unexpected surges in demand. Firms may carry a buffer stock to meet this eventuality.  In some situations stocks are essential. It would make no sense for a retailer not to carry a full range of stocks which customers could purchase at once and take away.

The Cost of Stock If holding stock carries so many obvious advantages, one might wonder why it should be questioned. If we look at stocks more closely, we can identify a number of problems.  Interest charges All stocks represent funds tied up – the business has incurred cost in building them up and they are not bringing in any revenue from sales. The funds involve an interest cost even if they were not borrowed. If these funds were not tied up in stock, they could be earning interest which the business is now foregoing. In the example above, in Quarter 1 stocks at 55 units represent nearly 46% of the current rate of production of 120 units. This could represent comparatively large funds being tied up.

 Rent Stocks occupy floor area which has a rent value. If stocks were not held, the floor area could be given over to some other use in the business, rented out to another user or even sold.  Handling costs All stocks need looking after. Some warehouse staff and equipment such as forklift trucks and shelving will be needed. Some stock management systems are computerised.  Security Stocks need to be held securely, possibly at some cost to the business depending on the nature and location of the stock. There will also be the extra costs of insurance.  Shrinkage, damage and deterioration Even where security is tight, stock losses occur due to pilferage or mishandling. Stocks can also suffer from deterioration due to poor storage conditions.  Obsolescence There is always the danger that stock will become unsaleable if it becomes out of date because of changes in fashion or other unpredictable events. It is clear, then, that stocks can represent a major cost to a business. Indeed, there is a strong view that stock equals waste: stock earns nothing and involves a range of costs as well as risks. This view implies we should look for ways to reduce stockholding as far as possible. One approach to this is the move to "just-in-time" (JIT) systems.

Just-in-Time (JIT) Systems The essence of JIT involves a complete reversal of the traditional production and stock systems. JIT means producing for sale and not for stock. The aim is to operate with, ideally, zero stock. In practice, this is not usually possible, but something approaching it can be achieved. A business will wait to receive a customer order and then react quickly to meet it by producing to that order. Of course, this also means that the firm's own suppliers will need to be very flexible. In principle, the system sounds simple enough but it does involve what amounts to a revolution in business operations.  Production With traditional methods, a flow line production system at a planned rate makes sense. With JIT, this is not possible because the business now produces to customer order. This implies batch production. If this is applied to our garden furniture producer, we might have a dealer ordering 80 sets. The company, under the JIT system, would have none in stock, but would attempt to manufacture a batch of 80 units as quickly as possible to meet the agreed delivery date. If production is to be this flexible, there are implications for both machinery and workforce. (a) Machinery The last thing the business needs when a big order comes in is for a vital piece of equipment to fail. To try to reduce the chances of this happening, major changes are needed to maintenance and repair systems. One solution is to introduce a system of preventative maintenance. Instead of waiting for machinery to break

down and then repairing it, the company's engineering fitters look for potential faults and try to prevent breakdown by corrective action. This should ensure that when a rush order comes in, the machinery and equipment will function properly. (b) Workforce With JIT, it no longer makes sense to have full-time employees working standard 40-hour weeks. Staff are now only needed when orders come in. What the business will now want is a much more flexible workforce. Flexible, that is, in two ways: (i) Time flexible – This may be achieved by using more part-time or temporary staff. Other options include putting staff onto annual hours contracts instead of weekly hours. For example, a worker may be contracted to work 2,200 hours per year, but when those hours are required by the firm depends on when customer orders come in and when production staff are needed. (ii) Flexible skills. – It can be very important for workers to be able to move from one job to another. For example, if a worker is absent, it is important that another worker can carry out that person's tasks so that production is not delayed. This flexibility implies training costs for the business. The workforce would be expected to work long hours at some times and very few or none at others. They will be expected to move from job to job within the factory. There is no room for demarcation issues.  Suppliers If the business is aiming to produce to customer order rather than for stock it will be looking to reduce its holdings of raw materials and parts stocks as well as its finished goods stocks. It will want to order these from suppliers only when they are needed. If this is to happen, then changes in the relationship with suppliers will have to take place. (a) The business may want to reduce the number of suppliers to facilitate the ordering process. Some businesses go as far as single sourcing – i.e. having only one supplier for a particular part. (b) Another option is to agree long-term contracts with suppliers to give them some guarantee of continued orders even if the timing of them is to change. (c) The business will want to speed up the process by which it orders its supplies, for example by using communication and information technology.  Quality One of the more important implications of JIT is that product quality needs to be maintained or improved. There can be no question of either work in progress or finished goods being rejected when production is focussed on specific delivery targets. Most businesses use quality control methods to deliver product quality. In essence, this relies on inspection taking place at various points in the production process. With changes to batch production a move to quality assurance may be more effective. Quality assurance means trying to achieve built-in quality. An important aspect of this is to make everyone in the organisation responsible for the quality of their work and not rely on inspection teams. This implies policies of empowerment for the workforce and, perhaps, also encouraging work teams to develop.

 Management There will be very clear implications for the management of the business. Management systems have to become more flexible and responsive, and time management will have a higher priority. These factors may mean the business having to abandon its traditional management methods. If management is to be more flexible and responsive, then there is less room for extended hierarchies or bureaucracy. Business will look to reduce hierarchical structure by taking out layers of management, a process known as "delaying". The most likely casualties will be found amongst middle management rather than with senior or junior management. This will mean a more direct link between strategic management and operational management levels. There will also be a need to attack bureaucratic systems where these hinder quick response times and organisational flexibility. Overall, it is clear that a move to JIT involves more than just changes to stockholding policies. The implications for the business as a whole are far reaching if JIT is to be successful.

D. QUALITY

In recent years there has been a developing recognition in industry, commerce and public services of the need to promote quality if organisations are to prosper.

Basic Principles of Quality Management have at their disposal a set of techniques which assist the smooth running of the production process and help to ensure reliability in terms of quality and meeting delivery dates. This set of techniques is known as the "3 Ss" – standardisation, simplification and specialisation.  Standardisation Standardisation is the process of determining the best sizes, types, qualities, etc. of materials, components and products, and consistently using these once they have been established. Some of the advantages of standardisation are similar to those stated below for simplification. The two terms have similar meanings, hence the possession of similar advantages. Other advantages are: (a) Parts are made interchangeable and common to many products, thus allowing long production runs with lower costs. (b) The planning and execution of production are simplified, again with lower costs. (c) Lower tooling and set-up costs are obtained with longer production runs. (d) The same quality can be obtained consistently, and purchasing is simplified; possible misunderstandings are eliminated. The main disadvantage of standardisation is that it may retard new inventions and developments. The consumer should, through standardisation, be able to purchase at a lower price, but if the product is inferior, because a change in design that would improve that product is being held back, then the consumer is paying a great deal indirectly by not being able to obtain maximum satisfaction. In other words, the price is being kept low by not giving the consumer what he or she should have. Every industrialised nation has a National Standards Organisation (NSO or ONS). In Britain much progress in standardisation has been made through the efforts of the

British Standards Institution which was the first national standards body in the world. The Institution's yearbook describes it as: "The approved body for the preparation and promulgation of national standards covering, inter alia, methods of test, terms, definitions and symbols, standards of quality of performance or of dimensions, preferred ranges, and codes of practice." BSI establishes written standards for a wide variety of products and services of commercial significance, including standards for quality management systems (BS 5750) and total quality management (BS 5850). These have now been superseded by a series of standards from the International Organization for Standardization (ISO 9000 series), providing wider recognition of quality.  Simplification Closely linked with standardisation is the process of simplification, which involves a reduction in the number of types manufactured or used, in the case of internal supplies, tools, consumables, etc. In fact standardisation and simplification are, for most purposes, one and the same and, when an organisation has a standardisation programme, it usually includes simplification techniques. The motor car industry has, for many years, been at the forefront in standardisation and simplification procedure. When separate companies were involved, progress was slow, but since the organisation of the industry worldwide into comparatively few groups, progress has been rapid. This has meant much less choice for the consumer, and it is a major reason for the increasing number of imported cars in the UK. The advantages may be summarised as follows: (a) The reduction in variety gives the benefits associated with large-scale manufacture resulting from the better absorption of tooling and setting-up costs, the reduction in unit labour costs, the use of special-purpose machines and lower material costs arising from bulk-buying. (b) Stock inventories are lower. (c) Quality is more consistent. (d) Marketing tends to be simpler and cheaper. (e) Parts for repair and service tend to be more easily available, at lower cost. The disadvantages are: (a) Customers have less choice. (b) The implementation of improvements in design or quality, which could be made as a result of new discoveries or natural progression, tends to be delayed because of the cost involved. (c) Where changes are made, stocks become redundant and often the cost is very high, offsetting some of the accrued benefit. (d) There is a tendency to constrain innovative designs. On balance, though, the widespread benefits of a properly considered standardisation and simplification policy are obvious.  Specialisation There are a number of applications of the term "specialisation". (a) It may relate to a company carrying out only part of the total production process for a product. This was a widespread feature of the cotton industry, where

separate firms were engaged in the separate processes of carding, spinning, weaving, dyeing and finishing. Much of this specialisation has now disappeared as a result of rationalisation of the industry, and this also applies to other industries. (b) In a more modern context, companies specialise in a relatively narrow range of products – for example a manufacturer of hi-fi speakers, or a car producer who specialises in only one or two models of a hand-built car. Similarly, multinational motor manufacturers not only have separate plants for different models but also have plants specialising in, say, engines, which are used by their factories worldwide. (c) Probably the greatest application of specialisation techniques, however, is within the company organisation, where separate divisions or factories may specialise in components or processes, or within a factory, where individual departments may specialise. The ultimate is worker specialisation, where tasks performed by operatives are broken down into small, repetitive functions. The advantages of specialisation arise from the greater skills that can be applied in the restricted unit, the lower costs arising from repetition, the reduction in variety, and the greater control possible over capital resources, stock levels and overhead costs generally. Specialisation also has its disadvantages. The cost of meeting change necessitated by market or technology factors may be high, and may result in change being delayed. Product specialisation often leaves a unit defenceless against market changes, and operator specialisation is considered a major factor in industrial unrest. The degree of specialisation and the areas involved are a matter of management policy, but the application affects the work of the designer and the nature of the design and development philosophy.

Managing Quality The starting point is to ensure reliability and uniformity of quality. Reliability begins with the design and specification for the product. Designs will have been tested for reliability by test production runs. In the production process itself, inspection was initially the main element of a quality policy. Quality systems have since been developed to incorporate a variety of other concepts such as zero defect, right first time, statistical process control and total quality management. It is convenient to think of four levels of quality activities:  Inspection is concerned with identifying failures and perhaps rectification, but is seldom involved in prevention activities.  Quality control consists of all the planned activities within the factory fence to promote quality.  The perspective of quality assurance has a wider boundary and considers suppliers, clients, trained personnel, systems audits etc.  The new concept of total quality management could be considered as quality assurance with the addition of a "human factors" perspective. Quality systems encompassing these elements come at a cost. However, in considering costs, two sets of figures must be taken into account:  Non-conformance – The costs of detecting faulty goods, e.g. the costs of the inspection process. Also there are the costs of preventing faults occurring – that is, the costs of raising quality awareness and creating a culture of quality.

 Conformance – The savings that arise from effective quality control: there will be fewer faulty goods scrapped and fewer returned as rejects. So a considerable saving may be made. The economics of quality control become even more favourable if the economic consequences of the benefits listed below are taken into consideration. The benefits of quality control can go far beyond the savings in scrap costs. These benefits include:  Improved customer satisfaction and confidence, which can result in increased sales and profits.  Improved design of products and gains through simplification.  Workers will have increased pride in their products.  A favourable corporate reputation for quality. Dynamic quality control and assurance concentrates on proactive systems.  Identifying where problems may arise. There are three main areas where quality deficiencies may be located: (a) Workers' problems – poor quality may arise from careless or disinterested workers. In addition poorly trained workers may lack the ability to produce good quality even when trying hard. In order to provide good quality, workers must know what to do and how to do it well. Low morale and lack of motivation can lower quality. (b) Management problems – poor quality may arise from inadequate leadership or planning, poor training and a lack of interest in quality. (c) Working conditions – good working conditions are a prerequisite for high quality; good heating, lighting and layout provide an environment conducive to quality production.  Taking actions to ensure quality. Modern management experts put forward positive ideas to make quality systems more dynamic such as: (a) Self-checking – the task of checking work is devolved to the individual worker. This raises the profile of the importance of quality while at the same time enhancing the worker's role. (b) Kaizen – a Japanese term meaning "continuous improvement". This process encourages all employees to suggest improvements and to eliminate "muda" (the Japanese term for "waste"). Quality is seen as an everyday function of work. (c) Benchmarking – this is the setting of competitive performance standards against which progress can be measured. These standards are based on what the market leaders are achieving. This ensures that managers focus on the competitive environment and take account of what their nearest rivals are achieving.

Total Quality Management Total Quality Management (TQM) is a philosophy of company-wide quality management and improvement. It is defined by the DTI as: "A way of managing to improve the effectiveness, flexibility and competitiveness of a business as a whole. It applies just as much to service industries as it does to manufacturing. TQM involves whole companies getting organised, in every department, every activity, and every single person, at every level. For an organisation to be truly effective, every single part of it must work properly

together, because every person and every activity affects and in turn is affected by others." The thirteen elements which make up TQM are generally presented as a series of steps. An organisation needs to build quality through the steps one by one, putting in place systems to establish each as a fundamental principle of the organisation.

Figure 6.1: The Steps to TQM

The essence of TQM is that the emphasis on quality should permeate the whole organisation. Drucker identifies eight performance areas which are critical to the long-term success of an enterprise. It is useful to adapt Drucker's key areas to the assessment of TQM and Figure 6.2 sets out the contribution of TQM.

Performance area TQM concerns

Market standing How high is the reputation for quality of the firm in the eyes of its customers, its competitors, its own employees and the public?

Innovation Are innovations and research and development activities geared towards the continual improvement of quality?

Productivity Is any increased productivity compatible with maintaining and increasing quality?

Resources Are the resources of the firm being directed to the pursuit of quality?

Profitability Are adequate profit levels being combined with quality goods and services?

Manager performance Are managers giving quality the priority it deserves?

Worker performance and Are workers imbued with the idea of quality and are attitude they putting this into practice in their work?

Public responsibility Do ideas of quality apply to the public good, e.g. high quality of environmental concern, product safety, etc?

Figure 6.2: Contribution of TQM to Organisational Performance

Quality Circles (QCs) In order to bring about employee involvement, managements have made use of the technique known as quality circles. A quality circle may be defined as a voluntary group of employees who meet regularly with the objective of improving the way in which their organisation provides quality of goods and services for its customers. The roots of the quality circle concept are in suggestion schemes, where employees put forward their ideas on how to improve the performance of the organisation. The basic idea of quality circles is that people of all levels of an organisation are capable of making useful contributions to its success. This contribution can be accomplished by putting forward ideas and taking on planning and decision-making actions. Supporters of the quality circle concept argue that circle members have first-hand experience of the problems at grass-roots level in their own organisation. These employees may have many useful ideas for increasing efficiency, innovation, safety, etc. Quality circle members receive training in the analysis of problems and decision-making techniques. Quality circles are a group activity and can act as a strong motivator for employees to improve the quality of goods and services. The introduction of quality circles can change the whole atmosphere of an organisation; it breaks down the "them and us" barriers as employees come to feel that they are important and valued members of the organisation. This changed attitude can provide a framework

© ABE and RRC The Production Function 107 within which quality can be improved. QC membership also improves the problem-solving skills of all those involved. The basic requirements to ensure best results from QCs are as follows.  Management must be enthusiastic about the idea of quality circles and make it crystal clear that they value the views of their employees and respect the expertise that comes from practical experience in the work situation.  Management has to give full information about the quality circle concept to all staff. The role and function of the circles should be explained and workers should be encouraged to join.  It is advisable for membership of quality circles to be voluntary, because compulsion is not a good way to bring out the best in circle members.  Management should provide good meeting rooms and conditions for regular circle meetings.  Quality circles should not be so large that they become unwieldy nor so small that there is too restricted a pool of talent. Between 8 and 10 members are generally suitable.  Management should ensure that, when quality circles make sound decisions, they are implemented. If circle members see management only paying lip service to their ideas they will soon lose interest in the quality circle concept.  Management should provide appropriate training opportunities for circle leaders and members to acquire the necessary skills of debate, analysis and decision-making.  Trade unions with members working in the organisation should be assured that QCs are not a threat to their functions. QCs should not tackle problems which are the rightful preserve of trade unions.  Management should provide a facilitator to assist the setting up and early running of QCs, e.g. a middle manager who volunteers for the task. However, as soon as it is up and running the QC should be independent and solve its own problems.  The role of the QC leader is crucial; this may be taken by a supervisor or a senior employee. The leader should have problem-solving skills and encourage the members.

Quality Back-Up Despite every effort, there will invariably be dissatisfied customers. Whether the business offers a formal warranty or guarantee or not, these problems must be addressed as part of a quality system. Reasons for customer complaints will include:  Faulty goods or inadequate service  Customers may have bought the wrong goods for the purpose they had in mind  There may have been errors in delivery Procedures for dealing with complaints include:  The appointment of a senior manager responsible for controlling the whole complaints procedure.  Speedy acknowledgment when complaints are received.  Swift classification of complaint – justified/unjustified.  Speedy steps to satisfy customers with justified complaints – replacement, refund, allowance as appropriate.

 Explanations of why a complaint is deemed unjustified sent to customers, with the offer of impartial arbitration if they still feel aggrieved.  Search for the cause of justified complaints within the organisation.  Steps to rectify the situation and so avoid further customer complaints.  Providing such high quality of service when dealing with the complaining customer as to turn the customer into a sales promotion for further purchases of the firm's goods.

Study Unit 7 The Marketing Function

Contents Page

Introduction 111

A. The Nature of Marketing 112 Marketing as a Philosophy and a Set of Tactics 112 The Marketing Management Process 113 The Marketing Mix 114 Not-For-Profit Marketing 116 Social Responsibility and Marketing 116

B. Market Analysis and Research 116 The Marketing Environment 117 Identifying and Responding to Changing Needs 120 Researching Customers' Changing Needs 121

C. Marketing Plans 122 Elements of the Marketing Plan 122 Relationship to the Corporate Plan 123

D. Customers and Markets 123 Market Segmentation 124 The Bases for Segmentation 125 Target Marketing 127

E. The Product 127 The Composition of the Product Offer 128 The Product Life Cycle 128 Positioning Strategy 129 Product Differentiation and Brands 131

F. Pricing 132 Cost-Based Pricing 133 Competition-Based Pricing 133 Demand-Based Pricing 133 (Continued over)

G. Promotion 134 Advertising 134 Sales Promotion 135 Public Relations 135 Direct Marketing 136 The Message 136 Campaign Planning 137

H. Distribution 137

I The Marketing Mix and the Product Life Cycle 138

INTRODUCTION

Marketing puts customers at the centre of a firm's activities. Rather than producing goods and services and then seeing if people buy them, companies should focus on understanding customers' needs and meeting these needs better than the competition. This marketing orientation underpins the concept of marketing and it is this with which we start the unit. These fundamentals of marketing include the marketing management process and the "marketing mix" which defines what is offered to customers and how. Our second area of study is the marketing environment and the methods used by marketing managers to keep in touch with changes in it. Organisations exist in a complex environment. That environment comprises customers who bring revenue into the organisation, and suppliers who provide it with raw materials. There are also many other elements of the environment, such as legislation and social trends, which can have a major impact on a company. Marketing is essentially about satisfying the needs of customers efficiently and effectively, so marketing managers must continually look for evidence of changing needs. It must also look for factors that might affect its ability to turn inputs into outputs efficiently and effectively. Customers and products form the heart of a company's marketing strategy. A thorough understanding of customers' needs leads to the development of products that will satisfy those needs better than the competition. Companies cannot hope to understand each customer individually, so instead we must talk about segments of buyers who share broadly similar characteristics. We go on, therefore, to discuss the bases for market segmentation. Finally we consider the elements of the marketing mix – the set of decisions which marketing managers make in order to configure their total product offer so that it meets the needs of buyers. It is usual to examine these as the four Ps of marketing. The first of these is the product itself and we look at how products are developed and positioned to give a company a competitive advantage in the eyes of the market segments. The three further elements are price, promotion and place, and these are used to bring about a consumer response. It is important to recognise that the marketing mix will change during the product life cycle. The accent on each of the four Ps will change as competition increases and the product eventually reaches its decline stage. Objectives When you have completed this study unit you will be able to:  Describe the essential features of a firm's marketing orientation.  Identify the elements of the marketing mix and their role in marketing management.  Describe the nature of the marketing environment and its impact on marketing activities of organisations.  Explain the ways in which marketing managers gather information about their environment and respond to changes in it.  Discuss the nature of customers and their needs.  Describe the basis for identifying segments of customers.  Identify the elements that make up the product offer.  Assess the interaction between market segmentation, product development and product positioning.  Recognise the advantages and disadvantages of different pricing methods.  Explain the role of promotion and the elements of the promotional mix.

 Recognise the need for effective and efficient distribution methods.  Understand the relationship between the marketing mix and the product life cycle.

A. THE NATURE OF MARKETING

Marketing is essentially about marshalling the resources of an organisation so they meet the changing needs of the customers on whom the organisation depends. As a verb, marketing is all about how an organisation addresses its markets. There are many definitions of marketing which generally revolve around the primacy of customers as part of an exchange process. Customers' needs are the starting point for all marketing activity. Marketing managers try to identify these needs and develop products which will satisfy a customer's needs through an exchange process. The Chartered Institute of Marketing provides a typical definition of marketing: "The management process which identifies, anticipates and supplies customer requirements efficiently and profitably". While customers may drive the activities of a marketing-oriented organisation, the organisation will only be able to continue serving its customers if it meets its own objectives. Most private sector organisations operate with some kind of profit-related objectives, and if an adequate level of profits cannot be earned from a particular group of customers, a firm will not normally wish to meet the needs of that group. Where an organisation is able to meet its customers' needs effectively and efficiently, its ability to gain an advantage over its competitors will be increased (for example, by allowing it to sell a higher volume and/or at a higher price than its competitors). It is consequently also more likely to be able to meet its profit objectives.

Marketing as a Philosophy and a Set of Tactics We need to distinguish between marketing as a fundamental philosophy and marketing as a set of tactics. The tactics are unlikely to be effective in a company that hasn't taken on board the full philosophy of marketing. As a business philosophy, marketing puts customers at the centre of all the organisation's considerations. This is reflected in basic values such as the requirement to understand and respond to customer needs and the necessity to constantly search for new market opportunities. In a truly marketing-oriented organisation, these values are instilled in all employees and should influence their behaviour without any need for prompting. For a fast food restaurant, for example, the training of serving staff would emphasise those items (such as the speed of service and friendliness of staff) which research had found to be most valued by existing and potential customers. The personnel manager would have a selection policy which recruited staff who could fulfil the needs of customers rather than simply minimising the wage bill. The accountant would investigate the effects on customers before deciding to save money by cutting stock holding levels. It is not sufficient for an organisation to simply appoint a marketing manager or set up a marketing department – viewed as a philosophy, marketing is an attitude which pervades everybody who works for the organisation. It is often said that if a company has done its marketing effectively, its products should be so well designed for customers that they "sell themselves". Marketing is therefore much more than just selling. To many people, marketing is simply associated with a set of techniques. As an example, market research is a technique for finding out about customers' needs and advertising is a technique to communicate the benefits of a product offer to potential customers. However, these techniques can be of little value if they are undertaken by an organisation which has not fully taken on board the philosophy of marketing.

The techniques of marketing also include, among other things, pricing, the design of channels of distribution and new product development. Although many of the chapters of this book are arranged around specific techniques, it must never be forgotten that all of these techniques are interrelated and can only be effective if they are unified by a shared focus on customers. Many companies claim to be "marketing oriented" but their words are greater than their actions. Here are some tell-tale signs of companies who are probably not truly marketing oriented.  In the car park, the prime parking spots are reserved for directors and senior staff rather than customers.  Opening hours are geared towards meeting the needs of staff rather than the purchasing preferences of customers.  Management's attitude towards lax staff is conditioned more by the need to keep internal peace than the need to provide a high standard of service to customers.  When confronted with a problem from a customer, an employee will refer the customer on to another employee without trying to resolve the matter themselves ("it's not my job").  The company listens to customers' comments and complaints, but has poorly defined procedures for acting on them.  Advertising is based on what senior staff want to say, rather than a sound analysis of what prospective customers want to hear.  Goods and services are distributed through channels which are easy for the company to set up, rather than what customers prefer.

The Marketing Management Process Marketing is an ongoing process which has no beginning or end. It is usual to identify four principal stages of the marketing management process which involve asking the following questions:

Analysis Where are we now?

Planning Where do we want to be?

Implementation How will we get there?

Control Did we manage to get there?

Figure 7.1: The Marketing Management Process

 Analysis Where are we now? How does the company's market share compare to its competitors? What are the strengths and weaknesses of the company and its products? What opportunities and threats does it face in its marketing environment?  Planning Where do we want to be? What is the mission of the business? What objective should be set for the next year? What strategy will be adopted in order to achieve those objectives (e.g. should the company go for a high price/low volume strategy, or a low price/high volume one)?  Implementation How are we going to put into effect the strategy which leads us to our objectives?  Control Did we achieve our objectives? If not, why not? How can deficiencies be rectified? In other words, go back to the beginning of the process and conduct further analysis.

The Marketing Mix The concept of the marketing mix was first given prominence by Borden in 1965. He described the marketing manager as: "a mixer of ingredients, one who is constantly engaged in fashioning creatively a mix of marketing procedures and policies in his efforts to produce a profitable enterprise". A marketing manager can be seen as somebody who mixes a set of ingredients to achieve a desired outcome in much the same way as a cook mixes ingredients for a cake. At the end of the day, two cooks can meet a common objective of baking an edible cake, but use very different sets of ingredients to achieve their objective. Marketing managers are essentially mixers of ingredients, and as with the cook, two marketers may each use broadly similar ingredients, but fashion them in different ways to end up with quite distinctive product offers. The nation's changing tastes result in bakers producing new types of cake, and so too the changing marketing environment results in marketing managers producing new goods and services to offer to their markets. The mixing of ingredients in both cases is a combination of a science (learning by a logical process from what has proved effective in the past) and an art form, in that both the cook and marketing manager frequently come across new situations where there is no direct experience to draw upon. Here, a creative decision must be made. The marketing mix is not a theory of management which has been derived from scientific analysis, but a conceptual framework which highlights the principal decisions marketing managers make in configuring their offerings to suit customers' needs. The tools can be used both to develop long-term strategies and short-term tactical programmes. There has been debate about which tools should be included in the marketing mix. The traditional marketing mix has comprised the four elements of product, price, promotion and place. A number of authors have additionally suggested adding people, process and physical evidence decisions. There is overlap between each of these headings and their precise definition is not particularly important. What matters is that marketing managers can identify the actions they can take which will produce a favourable response from customers. The marketing mix has merely become a convenient framework for analysing these decisions. A brief synopsis of each of the mix elements is given below.

 Products These are the means by which organisations satisfy consumers' needs. A product in this sense is anything which an organisation offers to potential customers which might satisfy a need, whether it is tangible or intangible. After initial hesitation, most marketing managers are now happy to talk about an intangible service as a product.  Pricing This is a critical element of most companies' marketing mix, as it determines the revenue which it will generate. If the selling price of a product is set too high, a company may not achieve its sales volume targets. If it is set too low, volume targets may be achieved, but no profit earned.  Promotion This is used by companies to communicate the benefits of their products to their target markets. Promotional tools include advertising, personal selling, public relations, sales promotion, sponsorship, and, increasingly, direct marketing methods.  Place These decisions involve determining how easy a company wishes to make it for customers to gain access to its goods and services. This involves deciding which intermediaries to use in the process of transferring the product from the manufacturer to the final consumer (usually referred to as designing a channel of distribution) and deciding how physically to move and handle the product as it moves from manufacturer to final consumer.  People These decisions are particularly important to the marketing of services. In the services sector, people planning can assume great importance where staff have a high level of contact with customers.  Process These decisions are again of most importance to marketers in the services sector. Whereas the process of production is usually of little concern to the consumer of manufactured goods, it is often of critical concern to the consumer of "high contact" services.  Physical evidence This is important to guide buyers of intangible services through the choices available to them. This evidence can take a number of forms, e.g. a brochure can describe and give pictures of important elements of the service product and the appearance of staff can give evidence about the nature of a service. The definition of the elements of the marketing mix is largely intuitive and semantic. However, dividing management responses into apparently discrete areas may lead to the interaction between elements being overlooked. Promotion mix decisions, for example, cannot be considered in isolation from decisions about product characteristics or pricing. Within conventional definitions of the marketing mix, important customer-focused issues, such as quality of service, can become lost. A growing body of opinion is therefore suggesting that a more holistic approach should be taken by marketing managers in responding to their customers' needs. This view sees the marketing mix as a production-led approach to marketing in which the agenda for action is set by the seller and not by the customer. An alternative relationship marketing approach starts by asking what customers need from a company and then proceeds to develop a response which integrates all the functions of a business in a manner which evolves in response to customers' changing needs.

Not-For-Profit Marketing More recently, marketing has been adopted by various public sector and not-for-profit organisations, reflecting the increasingly competitive environments in which they now operate. Within the public and not-for-profit sectors, financial objectives are often qualified by non-financial social objectives. An organisation's desire to meet individual customers' needs must be further constrained by its requirement to meet these wider social objectives. In this way, a local college may set an objective of providing a range of programmes for disadvantaged members of the local community, knowing that it could have earned more money by using its facilities to cater for full fee-paying users. Nevertheless, marketing can be employed to achieve a high take-up rate among this group, persuading them to spend their time and money at the college rather than on other activities. If an organisation has a market which it needs to win over, then marketing has a role. But without markets, can marketing ever be a reality? Many organisations claim to have introduced marketing when in fact their customers are captive, with no marketplace within which they can choose competing goods or services. What passes for marketing may therefore be little more than a laudable attempt to bring best practice to their operations in selected areas, for example in providing customer care programmes for front-line staff. But if customers have to come to the company anyway (as they do in the case of many local authority services), is this really marketing?

Social Responsibility and Marketing Traditional definitions of marketing have stressed the supremacy of customers, but this is increasingly being challenged by the requirement to satisfy the needs of wider stakeholders in society. There have been many recent cases where companies have neglected the interests of this wider group with disastrous consequences. The image of the Shell oil company suffered badly after it had tried to dump a disused oil platform in the North Sea, creating a perception of the company as an uncaring guardian of the natural environment. The opposite can also be true, however, where companies go out of their way to be good citizens. The Body Shop is a classic example of a business whose stance on the environment and not being involved in testing products on animals has contributed to much of its success. However, it is often difficult to quantify the actual impact on sales of taking a socially responsible stance. There are segments within most markets which place a high priority on ensuring that the companies which they buy from are "good citizens". Examples can be found among consumers who prefer to pay a few pennies extra for "dolphin friendly" tuna, or avoid buying from companies who test their products on animals. Wider issues are raised about the effects of marketing practices on the values of a society. It has been argued that by promoting greater consumption, marketing is responsible for creating a greater feeling of isolation among those members of society who cannot afford to join the consumer society where an individual's status is judged by what they own, rather than their contribution to family and community life. Much advertising has been criticised as being unethical, as in the case of advertising for tobacco and alcohol which may appeal against an individual's better judgment and bring bad health to millions, as well as the social costs of health care for sufferers.

B. MARKET ANALYSIS AND RESEARCH

We have defined marketing orientation in terms of a firm's need to begin its business planning by looking outwardly at what its customers require, rather than inwardly at what it would prefer to produce. The firm must be aware of what is going on in its marketing

© ABE and RRC The Marketing Function 117 environment and appreciate how change in its environment can lead to changing patterns of demand for its products. An environment in general terms can be defined as everything which surrounds and impinges on a system. Systems of many kinds have environments with which they interact – for example, a central heating system operates in an environment where key factors include the outside temperature and level of humidity. A good system will react to environmental change, for example by using a thermostat to increase the output of the system in response to a fall in the temperature of the external environment. The human body comprises numerous systems which constantly react to changes in the body's environment.

The Marketing Environment Marketing is a system which must respond to environmental change. Just as the human body may die if it fails to adjust to environmental change, businesses may fail if they do not adapt to external changes such as new sources of competition or changes in consumers' preferences. According to Kotler (1997), we can define an organisation's marketing environment as: "the actors and forces external to the marketing management function of the firm that impinge on the marketing management's ability to develop and maintain successful transactions with its customers". Naturally, some elements in a firm's marketing environment are more direct and immediate in their effects than others. Sometimes, parts of the marketing environment may seem quite far removed and difficult to assess in terms of their likely impact on a company. It is therefore usual to talk about a number of different levels of the marketing environment.  The micro-environment The micro-environment is that part of the environment which impacts directly on a company, such as suppliers and distributors. A company may deal directly with some of these (e.g. its current customers and suppliers), while others exist with whom there is currently no direct contact, but could nevertheless influence its policies (e.g. potential customers, government regulators and potential competitors). Similarly, an organisation's competitors could have a direct effect on its market position and form part of its micro-environment.  The macro-environment The macro-environment exists beyond the immediate micro-environment but can nevertheless affect an organisation. The macro-environmental factors cover a wide range of phenomena and represent general forces and pressures rather than the institutions which the organisation relates to directly. They can be characterised by the PEST analysis which we considered earlier in relation to organisations as a whole.  The internal marketing environment As well as looking to the outside world, marketing managers must also take account of factors within other functions of their own firm. This is often referred to as an organisation's internal marketing environment. The elements within each of these parts of an organisation's environment are illustrated schematically in Figure 7.2.

The Macro- Environment

Political Economic The Micro- Environment Customers Suppliers The Internal Environment Distributors Employees

Government Agencies

Social Technological

Figure 7.2: The Organisation's Marketing Environment

We consider three aspects of the macro-environment in a little more detail. (a) The economic environment Few business people can afford to ignore the state of the economy because it affects the willingness and ability of customers to buy their products. Marketers therefore keep their eyes on numerous aggregate indicators of the economy, such as gross domestic product, inflation rates and savings ratios. However, while aggregate changes in spending money may indicate a likely increase for goods and services in general, the actual distribution of spending power among the population will influence the pattern of demand for specific products. In addition to measurable economic prosperity, the level of perceived wealth and confidence in the future can be an important determinant of demand for some high-value services. (b) The social and demographic environment It is crucial for marketers to fully appreciate the cultural values of a society, especially where an organisation is seeking to do business in a country which is quite different to its own. Attitudes to specific products change through time and at any one time between different groups. Even in home markets, business organisations should understand the processes of gradual cultural change and be prepared to satisfy the changing needs of consumers. Consider the following examples of contemporary cultural change in western Europe and the possible responses of marketers:  Leisure is becoming a bigger part of many people's lives and marketers have responded with a wide range of leisure-related goods and services.  The role of women in society is changing as men and women increasingly share expectations in terms of employment and household responsibilities. As an example of this, women made up 47% of the UK paid workforce in 1997,

compared with 37% in 1971. Examples of marketing responses include cars designed to meet the aspirational needs of career women and ready-prepared meals which relieve working women of their traditional role in preparing household meals.  Greater life expectancy is leading to an ageing of the population and a shift to an increasingly "elderly" culture. This is reflected in product design which emphases durability rather than fashionableness.  The growing concern among many groups in society with the environment is reflected in a variety of "green" consumer products. There has been much recent discussion about the idea of "cultural convergence". Many companies have developed one product which is suitable for a global market, and there is some evidence of firms achieving this (for example Coca-Cola and McDonalds). The desire of a subculture in one country to imitate the values of those in another culture has also contributed to cultural convergence. This process is at work today in many developing countries where some groups seek to identify with western cultural values through the purchases they make. New challenges for marketing are posed by the diverse cultural traditions of ethnic minorities, as seen by the growth of chemists and grocers catering for specific ethnic minorities. Demography is the study of populations in terms of their size and characteristics. Among the topics of interest to demographers are the age structure of a country, the geographic distribution of its population, the balance between males and females, and the likely future size of the population and its characteristics. Changes in the size and age structure of the population are critical to many firms' marketing. Although the total population of most western countries is stable, their composition is changing. Most countries are experiencing an increase in the proportion of elderly people and companies who have monitored this trend responded with the development of residential homes, cruise holidays and financial portfolio management services aimed at meeting this group's needs. At the other end of the age spectrum, the birth rate of most countries is cyclical resulting in a cyclical pattern of demand for age- related products such as baby products, fashion clothing and family cars. There has been a trend for women to have fewer children and to have them later in life. There has also been an increase in the number of women having no children. Having fewer children has resulted in parents spending more per child (including more designer clothes for children rather than budget clothes) and has allowed women to stay at work longer (increasing household incomes and encouraging the purchase of labour-saving products). Alongside a declining number of children has been a decline in the average household size (from an average of 3.1 people in 1961 to 2.3 in 1997), with a particular fall in the number of very large households with five or more people and a significant increase in the number of one-person households. This has numerous marketing implications, such as increased demand for smaller units of housing and the types and size of groceries purchased. Marketers also need to monitor the changing geographical distribution of the population, between different regions of the country and between urban and rural areas. (c) The impact of technological change on marketing The pace of technological change is becoming increasingly rapid and marketers need to understand how technological developments might affect them in four related business areas:

 New technologies can allow new goods and services to be offered to consumers, such as telephone banking, mobile telecommunications and new drugs.  New technology can allow existing products to be made more cheaply, thereby widening their market through being able to charge lower prices (e.g. more efficient aircraft have allowed mass-market long-haul holiday markets to develop).  Technological developments have allowed new methods of distributing goods and services (for example, the Internet has allowed many banking services to be made available at times and places which were previously not economically possible).  New opportunities for companies to communicate with their target customers have emerged. The Internet is opening up new one-to-one communication channels, especially for service-based companies.

Identifying and Responding to Changing Needs You will recall that the relationship between a firm and its business environment is crucial to marketing success. There are many examples of firms who have neglected this relationship and eventually withered and died. To avoid this fate, a firm must understand what is going on its business environment and respond and adapt to environmental change. As organisations become larger and national economies more complex, the task of understanding the marketing environment becomes more formidable. Information about a firm's environment becomes crucial to environmental analysis and response. Information collection, processing, transmission and storage technologies are continually improving, as witnessed by the development of Electronic Point of Sale (EPOS) systems. These have enabled organisations to greatly enhance the quality of the information they have about their operating environment. It is becoming increasingly important for companies to manage this information as effectively as possible. Organisations learn about their environment using a number of sources of information. Marketing intelligence comprises unstructured sources of information used by marketers to paint a general picture of their changing environment. Intelligence can be gathered from a number of sources, such as newspapers, specialised cutting services, employees who are in regular contact with market developments, intermediaries and suppliers to the company, as well as specialised consultants. Marketing research complements marketing intelligence. Whereas the latter concentrates on picking up relatively intangible ideas and trends, marketing research focuses on structured and largely quantifiable data collection procedures. This can provide both routine information about marketing effectiveness (such as brand awareness levels or distribution effectiveness) and one-off studies (such as a survey of changing attitudes towards diet). In addition to collecting these external sources of data, companies can learn a lot about their environment by carefully examining data which they routinely collect. An analysis of sales patterns may reveal changes in the types of product bought by particular market segments, which in turn may be indicative of a change of attitudes in some groups of society. Collecting information about the environment is one thing, but analysing it and using it can be quite another. Large organisations operating in complex and turbulent environments therefore often build models of their environment, or at least sub-components of it. Some of these can be quite general, as in the case of the models of the national economy which many large companies have developed. From a general model of the economy, a firm can predict how a specific item of government policy (for example, increasing the basic rate of income tax) will impact directly and indirectly on sales of its own products. The management

© ABE and RRC The Marketing Function 121 of change is becoming increasingly important to organisations, driven by the increasing speed with which the external environment is changing. Organisations differ in the speed with which they are able to exploit new opportunities as they appear in their environment. Being the fastest company in a market to adapt can pay good dividends, so recent years have seen major attempts by firms to increase their flexibility, for example by moving human resources from areas in decline to those where there is a prospect of future growth.

Researching Customers' Changing Needs Definitions of marketing focus on a firm satisfying its customers' needs. But how does a firm know just what those needs are and how can it try to predict what those needs will be in a year's time, or five years' time? A small business owner in a stable business environment may be able to manage by just listening to his or her customers and forming an intuitive opinion about customers' needs and how they are likely to slowly change in the future. But such an informal approach is less likely to work in today's turbulent business environment, where the owners of very large businesses probably have very little contact with their customers. Marketing research is essentially about the managers of a business keeping in touch with their markets. The small business owner may have been able to do marketing research quite intuitively and adapt their product offer accordingly. Larger organisations operating in competitive and changing environments need more formal methods of collecting, analysing and disseminating information about their markets. It is frequently said that information is a source of a firm's competitive advantage and there are many examples of firms who have used a detailed knowledge of their customers' needs to develop better product offers which give them a competitive advantage. The range of techniques used by firms to collect information is increasing constantly. Indeed, companies often find themselves with more information than they can sensibly use. The great advances in EPOS technology has, for example, given retailers a huge amount of new data which not all firms have managed to make full use of. As new techniques for data collection appear, it is important to maintain a balance between techniques so that a good overall picture is obtained. Reliance on just one technique may save costs in the short term, but only at the long-term cost of not having a good holistic view of market characteristics. A good starting point for "secondary research" (or "desk research") is to examine what a company already has available in-house. Typically, a lot of information is generated internally within organisations, for example sales invoices may form the basis of a market segmentation exercise. To make the task of desk research as easy as possible, routinely collected information should be analysed and stored in a way that facilitates future use. Of course, a balance needs to be struck between having data readily available and the cost of collecting and storing data which may be subsequently used. The range of external sources of secondary data is constantly increasing, both in document and, increasingly, electronic format. These sources include government statistics, trade associations and specialist research reports. A good starting point for a review of these is still the business section of a good library. Where secondary research fails to provide a sufficiently clear picture of the marketing environment, a firm may resort to primary research (sometimes referred to as "field research"). Whereas secondary research involves collecting data which is old and in some sense "second-hand", primary research is collected to meet the specific needs of the company. It typically involves using quantitative and/or qualitative techniques to understand the nature of markets facing a company. Although the results are generally much more up to date and relevant to a company, this method of learning about the marketing environment is relatively expensive.

Market research has so far been described in terms of establishing customers' characteristics and preferences in a structured manner. Another approach is to gather relatively unstructured information about their environment in a format that is often referred to as "marketing intelligence". Business owners have for a long time developed the art of "keeping their ear close to the ground" through informal networks of contacts. With the growing sophistication of the business environment, these informal methods of gathering intelligence need to be supplemented. In contrast to market research, intelligence gathering concentrates on picking up relatively intangible ideas and trends, especially about competitors' developments. Marketing managers can gather this intelligence from a number of sources, including press cuttings services, listening to sales personnel and intermediaries and attending trade exhibitions and conferences.

C. MARKETING PLANS

Let us first make a point about definitions and be sure to distinguish marketing plans from marketing planning. The latter refers to the whole process of marketing activities, encompassing environmental analysis, setting of goals, development and selection of strategies, implementation of the plan, monitoring and control. Strategic marketing planning is the process of ensuring a long-term good fit between the requirements of an organisation's environment and the capabilities which it possesses. The process has been defined by Kotler as: "the managerial process of developing and maintaining a viable fit between an organisation's objectives, skills and resources, and its changing market opportunities. The aim of strategic planning is to shape and re-shape the company's business and products so that they yield target profits and growth". The importance of strategic planning varies between firms. In general, as organisations grow, their exposure to risk grows, and planning can be seen as a means of limiting that risk. As a process, marketing planning has no beginning or end, because the review following implementation feeds directly into an environmental analysis on which goals and strategies for the next period are based. While marketing planning is about a process, a marketing plan is a snapshot of this process at one point in time. A marketing plan usually describes the implementation task for the next 12 months ahead and becomes a "bible" which guides the work of all people in an organisation.

Elements of the Marketing Plan The strategic element of a marketing plan focuses on the overriding direction which an organisation's efforts will take in order to meet its objectives. The tactical element is more concerned with plans for implementing the detail of the strategic plan. The division between the strategic and tactical elements of a marketing plan can sometimes be difficult to define. Typically, a strategic marketing plan is concerned with mapping out direction over a five-year planning period, whereas a tactical marketing plan is concerned with implementation during the next 12 months. Naturally, many industries view their strategic planning periods somewhat differently. The marketing of capital-intensive projects, such as the Channel Tunnel, requires a much longer strategic planning period to allow for the time delays in developing new capacity and the fact that when capacity does become available, it will have a very long life with few alternative uses. On the other hand, some industries operate to much shorter strategic planning periods, where new productive capacity can be produced quickly and where the environment is too turbulent to allow serious long-term planning (for

© ABE and RRC The Marketing Function 123 example, an office cleaning contractor will probably not be able to develop a very detailed long-term strategic marketing plan). The "marketing mix" is often used to provide a series of headings for the marketing plan. There is nothing scientific about the 4 "Ps" of product, price, promotion and place. Some are more relevant than others to particular companies. For services companies, it is common to use a number of additional "Ps" of people, physical evidence and process. If you are asked to develop a marketing plan, the marketing mix will provide a useful structure for your answer, whether you are dealing with strategic or tactical elements of the plan. A third element of the marketing plan involves the development of contingency plans. These seek to identify circumstances where the assumptions of the original environmental analysis on which strategic decisions were based turn out to be false. For example, the planning of a new airport might have assumed that fuel prices would rise by no more than 10% during the plan period. A contingency plan would be useful to provide an alternative strategic route if, halfway through the plan period, fuel prices suddenly doubled and looked like remaining at the higher level for the foreseeable future, causing a fall in the total market for air travel (for example, the airport might have a contingency plan to increase its promotional expenditure or to identify alternative sources of revenue).

Relationship to the Corporate Plan A marketing plan cannot be seen in isolation within any organisation and you must be aware of how a marketing plan relates to an organisation's corporate plan. The basic idea of corporate strategic planning is to provide a framework within which a whole range of more detailed strategic plans can be developed (e.g. financial, operational, personnel). Corporate planning embraces other elements of the planning process in a horizontal and vertical dimension.  In the horizontal dimension, a corporate strategic plan brings together the plans of the specialised functions which are necessary to make the organisation work. The components of these functional plans must recognise interdependencies if they are to be effective. For example, a bank's marketing strategic plan which anticipates a 50% growth in sales of personal loans over a five-year planning period should be reflected in a strategic production plan which allows for the necessary processing capacity to be developed and a financial plan which identifies strategies for raising the required level of finance over the same time period.  In the vertical dimension, the corporate planning process provides the framework for strategic decisions to be made at different levels of the corporate hierarchy. Objectives can be specified in progressively more detail from the global objectives of the corporate plan, to the greater detail required to operationalise them at the level of individual operational units (or Strategic Business Units) and – in turn – for individual products.

D. CUSTOMERS AND MARKETS

Customers provide payment to an organisation in return for the delivery of goods and services and therefore form a focal point for the organisation's marketing activity. The customer is generally understood to be the person who makes the decision to purchase a product, and/or pays for it. In fact, products are often bought by one person for consumption by another, therefore the customer and consumer need not be the same person. For example, colleges must not only market themselves to prospective students, but also to their parents, careers counsellors and local employers. In these circumstances it can be difficult to identify who an organisation's marketing effort should be focused upon. For many public services, society as a whole benefits from an individual's consumption, and not just the immediate customer. In the case of health

© ABE and RRC 124 The Marketing Function services, society can benefit from having a fit and healthy population in which the risk of contracting a contagious disease is minimised. Different customers within a market have different needs which they seek to satisfy. To be fully marketing oriented, a company would have to adapt its offering to meet the needs of each individual. In fact, very few firms can justify aiming to meet the needs of each specific individual – instead, they target their product at a clearly defined group in society and position their product so that it meets the needs of that group. These sub-groups are often referred to as segments.

Market Segmentation You will recall that a focus on meeting customers' needs is a defining characteristic of marketing. Organisations which make presumptions about customers' needs, or produce goods and services which are chosen for their convenience in production, are probably not practising the marketing concept. A true marketing orientation requires companies to focus on meeting the needs of individual customers. In a simple world where consumers all have broadly similar needs and expectations, a company could probably justify developing a marketing programme which meets the needs of the "average" customer. In the early days of motoring, Henry Ford successfully sold as many standard, black Model T Fords as he was able to produce. In the modern world of marketing, few companies can have the luxury of producing just one product to satisfy a very large market. Some still can, for example water, gas and electricity utility companies generally produce a single standard of product for all of their customers. But this is the exception rather than the rule. Most companies face markets which are becoming increasingly fragmented in terms of the needs which customers seek to satisfy. So, while the customers of Henry Ford may have been quite happy to have a plain black car, today's car buyers seek to satisfy a much wider range of needs. Segmentation is essentially about identifying groups of buyers within a market who have needs which are distinctive in the way that they deviate from the "average" consumer. Some consumers may treat satisfaction of one particular need as a high priority, whereas to others this need may be regarded as being quite trivial. Consider the case of the new car market. Buyers no longer select a car solely on the basis of a car's ability to satisfy a need to get them from A to B. Additionally, a buyer may seek to satisfy any of the following needs:  To provide safety and security for themselves and their family.  To provide a cost-effective means of transport.  To give them status in the eyes of their peer group.  To project a particular image of themselves.  To be seen making a gesture towards the environment by buying a "green" car. There are many more possible factors which might influence an individual's choice of car. The important point is that the market is composed of buyers who have quite different priority needs and who approach the decision to buy a car in very different ways. Therefore the features which they each look for in a product offer may differ quite markedly from the "average" consumer. It follows therefore that a marketing plan which is based on satisfying the needs of the average buyer will be unlikely to succeed in a competitive marketplace. If another company can satisfy the needs of small specialist groups better, then the company which seeks to serve them with just an "average" product offer will lose business from this group. The process of identifying groups of buyers who differ in the needs which they seek to satisfy from a purchase is often referred to as market segmentation. We will define the process of market segmentation as:

"The identification of sub-sets of buyers within a market who share similar needs and who have similar buying processes". Market segmentation, then, is at the opposite end of a spectrum of marketing strategy from mass marketing. Some of the important distinctions between these two extremes are summarised below:

Mass Marketing Market Segmentation

Diversity of customers' needs Low High Variation in products offered by firms Low High "The customer" The average buyer Unique individuals

In an ideal world, each individual buyer would be considered as having a unique set of needs which they seek to satisfy, and firms would tailor their product offering to each of their customers. In the case of some expensive items of capital equipment bought by firms, this indeed does happen (for example, there are very few buyers of hospital body scanners in the UK, so firms can justifiably treat each customer as a segment of one). In the case of products which are relatively low in value and high in sales volumes, however, it would be impossible for firms to cater to each individual's unique needs.

The Bases for Segmentation People or firms within a market can be segmented according to a number of criteria. For sales of goods and services to private buyers, the following are typical segmentation criteria:  gender  socio-economic status  age  lifestyle  frequency of purchase  purpose of purchase  attitudes towards the product  geographical location. A number of specific methods of segmenting markets are considered in more detail below. These are not watertight definitions and you will recognise that they show considerable areas of overlap. (a) Demographic bases for segmentation Demography can be defined as the study of population characteristics and demographers have used a number of key indicators in their studies of populations. Typical bases for demographic segmentation include:  age – for example, many products such as chart music and cruise holidays are quite age specific;  the stage that they have reached in their family life cycle – for example, single adults often have very different needs to adults with dependent children;  gender – for example, consider how males and females typically have different criteria when choosing a new car;

 household composition – for example, single person households are less likely to buy large "economy" packs of products. (b) Socio-economic bases for segmentation It has been traditional to talk about class differences in the way that goods and services are purchased. A person's occupation is often a good indicator of the products they are likely to purchase. You may have come across a number of measures of socio- economic groups, for example the frequently quoted terms A, B, C1, C2, D and E which describe groups with different socio-economic circumstances. Marketers find the concept of social class too value laden and imprecise to be of much practical use. Instead, more objective indicators of social class are used, in particular occupation and income. (c) Psychographic bases for segmentation So far, most of the bases for segmentation have been reasonably measurable. However, they are often criticised for missing the unique personality factors that distinguish one person from another. Under the heading of psychographic factors, we can identify a number of factors:  lifestyle – for example, compare the differing lifestyles of your colleagues, expressed in such ways as their need for excitement, status, etc.;  attitudes – for example, compare people's attitudes towards organic food;  benefits sought – for example, some people may buy a watch for telling the time accurately, whereas others may buy it as a fashion accessory;  loyalty – for example, some buyers may feel more comfortable sticking with suppliers who they are familiar with, while others may be more adventurous. (d) Geodemographic bases for segmentation Marketers have traditionally used geographical areas as a basis for a market segmentation. Very often, there have been very good geographical reasons why product preferences should vary between regions (e.g. preferences in beer have traditionally varied between the north and south of England). Many companies have managed to adapt their product offer to meet the needs of different regional segments. National newspapers, for example, produce regional editions to satisfy readers' needs for local news coverage and advertisers' needs for a regional advertising facility. More recently, geographical segmentation has been undertaken at a much more localised level, and linked to other differences in social, economic and demographic characteristics. The resulting basis for segmentation is often referred to as geodemographic, the underlying idea being that where a person lives is closely associated with a number of indicators of their socio-economic status and lifestyle. This association has been derived from detailed investigations of multiple sources of information about people living in a particular neighbourhood. (e) Situational bases for segmentation A further group of segmentational variables can be described as situational because an individual may find him-/herself grouped differently from one occasion to the next – for example, an individual may seek a relaxing social meal at a restaurant on one occasion, but a faster business lunch on another occasion. In practice, companies would use a number of key variables which are most relevant to their product or market. Geodemographic segmentation has become particularly popular because of the close correlation between where an individual lives and other indicators of income, occupation and lifestyle. Companies are also likely to combine subjective approaches to segmentation with more traditional quantifiable techniques.

Target Marketing Identifying segments of a market is one thing. It is another to decide which of the many available market segments a company should aim at. These chosen segments are commonly referred to as target markets. The development of segmentation and target marketing reflects the movement of organisations away from production orientation towards marketing orientation. When the supply of goods is scarce relative to demand (or customers have very little choice of supplier), organisations may seek to minimise production costs by producing one homogeneous product which satisfies the needs of the whole population (think of the early days of Ford when customers could have "any colour Model T, as long as it is black"). Over time, increasing affluence has increased customers' expectations. Affluent customers are no longer satisfied with a basic car, but instead are able to demand one which satisfies an increasingly wide range of needs. To some, a car is not just for transport, but a symbol of status or an object of excitement. Furthermore, society has become much more fragmented – the "average" consumer has become much more of a myth, as incomes, attitudes and lifestyles have diverged. Alongside the greater fragmentation of society, technology is today allowing highly specialised goods and services to be tailored to ever smaller market segments. Using computer-controlled manufacturing techniques, cars can be tailored to each individual customer's needs as they come down the production line.

E. THE PRODUCT

Products are the focal point by which companies seek to satisfy customers' needs. The term "product" can mean many things to many people. Most people, when they consider marketing and the marketing of products, tend to think of fast-moving consumer goods (FMCGs) such as soap powder or chocolate bars. In fact, the term "product" can mean any tangible or intangible item that satisfies a need; it includes:  Material goods  Intangible services  Locations – for example, tourist destinations  People – for example, pop stars  Ideas – for example, ecological awareness  Combinations of the above It must be remembered that people only buy products for the benefits which they provide. In other words, a product is only of value to someone as long as it is perceived as satisfying some need, so we return to the important point we mentioned earlier of identifying the distinctive needs of specific groups of consumers. Although a truly marketing-oriented company will focus on customers, it is important to understand how product characteristics affect marketing. We can identify two major considerations which influence the type of marketing which is likely to be appropriate for a particular product or group of products.  Some products can be described as "high involvement", requiring extensive search and evaluation activity by the buyer – for example, the purchase of sugar calls for only very low levels of emotional involvement by the buyer, whereas this may be very high in the case of fashion clothing.  For some products, easy availability is crucial, whereas for other products buyers may be more willing to travel greater distances – for example, a buyer will expect a can of

soft drink to be available immediately and without having to travel to it, whereas the buyer would be prepared to travel further, and possibly wait, to buy garden furniture. These are just two factors that contribute towards the design of an appropriate marketing mix. Others could include buyers' price sensitivity, brand loyalty, frequency of purchase, etc. It is useful to categorise products in this way because marketers of one product can learn from the marketing of another product which may at first appear to be quite different, but is really in the same category.

The Composition of the Product Offer The product is essentially everything that is offered to the consumer. We can identify two important components of this "total product offer" – the core product and the secondary or "augmented product offer".  The core level Every product exists to satisfy a need and therefore an individual is searching for a product that at the very least will have satisfaction of this basic need as its core benefit. The best way to think of this is to consider an item and identify the key benefit from its ownership. For example, the core benefit of owning a car to most people is transport and the core benefit of undertaking a marketing course is personal development.  The secondary level The secondary level is used to describe a distinctive identity for a product. Such secondary elements may include: (a) Design – for example, all cars perform a basically similar function, but within its class the Volkswagen Beetle has distinctive styling which differentiates it from its new competitors. (b) Shape – many companies have used distinctive shapes (e.g. Toblerone) as a point of differentiation. (c) Packaging – this is needed to ensure that a product is delivered to customers in perfect condition. The packaging should enable both distributors and the end user to handle and transport the product from one place to another. In addition, packaging should also allow the product to be stored and the shape should therefore be conducive to stocking on shelves and, where appropriate, in the home, office or business. In addition to these functions, packaging should allow for the protection of the product from deterioration (in the case of perishable goods) and from breakage. (d) Intangibles – the secondary level of a product also includes intangible features such as pre-sales and after-sales service, guarantees, credit facilities, brand name, etc.; again, all providing a point of differentiation.

The Product Life Cycle Consumers need change over time, so it is important that products change over time to reflect this. The perfect example of this is that we no longer want to buy typewriters, but our appetite for mobile phones has increased. This leads us to the idea of a product life cycle. There is a general acceptance that most products go through a number of stages in their existence, just as humans and most living organisms go through a number of life cycle stages.  Introduction stage When a new product comes onto the market, there is likely to be a good deal of promotional effort on the part of the firm making the product to secure sales. It is likely that the firm has incurred high costs in the development of such a product which in the

early stages may not be covered by revenue. Potential customers for a new product may very well be few and far between and therefore sales in the early stages may be quite slow.  Growth stage If the new product becomes a success, more people may start to show an interest and start purchasing it. As more people buy, the firm will discover a number of cost savings in producing larger quantities. Raw materials can be purchased in bulk and therefore at a cheaper cost per unit. Machinery can start to be used to a greater capacity and individual employees will become far more efficient at producing larger quantities. Any initial teething problems with the product start to be ironed out and more people will purchase the product on the basis of word of mouth rather than merely the firm's formal promotional campaign. Falling costs and rising revenues improve profitability, and the firm can start to reap the benefits of economies of scale.  Maturity stage As sales of the product increase, other competitors are likely to be attracted to the market and as a result may start to compete on price. Promotion on the part of all competitors tends to increase and yet the number of customers for the product has ceased to grow. Over a period of time, the increase in sales starts to slow down.  Decline stage Eventually, sales of the product start to fall. A classical product life cycle is shown in Figure 7.3.

Sales Maturity Decline Growth

Introduction

Time Figure 7.3: The Product Life Cycle

It is actually quite difficult to measure a life cycle while it is happening, but much easier after a product has passed through it. Life cycle analysis may be difficult to apply for short-term forecasting purposes or developing short-term marketing operational decisions and it is therefore more useful in strategic planning and control decisions. Even so, there are many permutations to the basic product life cycle. For example, if sales are stabilising, it may be difficult to tell whether the product has reached its peak in terms of growth and is about to decline or whether there is just a temporary stabilisation due to external influences and that, if left alone, sales may very well start to increase once again in the near future.

Positioning Strategy Positioning strategy is used by a company to distinguish its products from those of its competitors in order to give it a competitive advantage within a market. Positioning puts a firm in a sub-segment of its chosen market; thus a firm which adopts a product positioning

© ABE and RRC 130 The Marketing Function based on "high reliability/high cost" will appeal to a sub-segment which has a desire for reliability and a willingness to pay for it. Positioning is about more than merely advertising and promotion but involves the management of the whole marketing mix. Essentially, the mix must be managed in a way that is internally coherent and sustainable over the long term. A marketing mix positioning of high quality and low prices may attract business from competitors in the short term, but the low prices may be insufficient to cover the costs of delivering high quality, and therefore profits may be unsustainable over the long term. A company must examine its opportunities and take a position within the market. A position can be defined by reference to a number of scales – level of comfort and price, for example, are two dimensions of positioning which are relevant to cars. It is possible to draw a position map in which the positions of key players in a market are plotted in relation to these criteria. A position map plotting the positions of selected cars in respect of their price and level of comfort ("quality") is shown in Figure 7.4. Both scales run from high to low, with price being a general indication of price levels charged relative to competitors and level of comfort a subjective evaluation of features provided with the car. The position map shows that most cars lie on a diagonal line between the high comfort/high price position adopted by Mercedes Benz and Lexus and the low price/low comfort position adopted by Proton and Lada. Points along this diagonal represent feasible positioning strategies for car manufacturers. A strategy in the upper left quadrant (high price/low quality) can be described as a "cowboy" strategy and generally is not sustainable. A position in the lower right area of the map (high quality/low price) may indicate that an organisation is failing to achieve a fair exchange of value. Of course, this two-dimensional analysis of the car market is very simplistic and buyers make judgments based on a variety of criteria. Low levels of comfort may be tolerated at a high price, for example, if a car carries a strong brand name.

High Mercedes Benz Lexus

Volkswagen

PRICE Ford Vauxhall

Skoda

Proton Low Lada

Low High QUALITY

Figure 7.4: A Product Positioning Map for Selected Cars

The example of cars used two very simplistic positioning criteria. In practice, a product can be positioned using many criteria, including:  Benefits or needs satisfied  Specific product features  Usage occasions  User categories

 Positioning in comparison with another product Selecting a product position involves three basic steps: (a) Analyse the market to identify the most profitable opportunities which have not yet been filled (and are unlikely to be filled) by competing products. (b) Evaluate alternative possible product positions. (c) Use the marketing mix to configure the total product offer so that it meets the needs of targeted segments better than any other product available.

Product Differentiation and Brands Branding lies at the heart of marketing strategy and seeks to remove a company from the harsh competition of commodity-type markets. By differentiating its product and giving it unique values, a company simplifies consumers' choices in markets which are crowded with otherwise similar products. Branding requires considerable investment by a company in product quality and promotion if a brand is to be trusted by customers. Out of such investment have emerged powerful global brands which are very valuable assets to their owners. Brand building has been described as the only way to build a stable, long-term demand at profitable margins. Through adding values that will attract customers, firms are able to provide a solid base for expansion and product development and protect themselves against the strength of intermediaries and competitors. There has been much evidence linking high levels of advertising expenditure to support strong brands with high returns on capital and high market share. Traditional economic theory is based on assumptions of perfectly competitive markets in which a large number of sellers offer for sale an identical product. All suppliers' products are assumed to be perfectly substitutable with each other and therefore, through a process of competition, prices are minimised to the level which is just sufficient to make it worthwhile for suppliers to continue operating in the market. To try to avoid head-on competition with large numbers of other suppliers in a market, companies seek to differentiate their product in some way. By doing so, they create an element of monopoly power for themselves, in that no other company in the market is selling an identical product to theirs. To some people, the point of difference may be of great importance in influencing their purchase decision and they would be prepared to pay a price premium for the differentiated product. Nevertheless, such buyers remain aware of close substitutes which are available and may be prepared to switch to these substitutes if the price premium is considered to be too high in relation to the additional benefits received. The co-existence of a limited monopoly power with the presence of many near substitutes is often referred to as imperfect competition. For a marketing manager, product differentiation becomes a key to gaining a degree of monopoly power in a market. It must be remembered, however, that product differentiation alone will not prove to be commercially successful unless the differentiation is based on satisfying clearly identified consumer needs. A differentiated product may have significant monopoly power in that it is unique, but if it fails to satisfy consumers' needs its uniqueness has no commercial value. Out of the need for product differentiation comes the concept of branding. A company must ensure that customers can immediately recognise its distinctive products in the marketplace. Instead of asking for a generic version of the product, customers should be able to ask for the distinctive product which they have come to prefer. A brand is essentially a way of giving a product a unique identity which differentiates it from its near competitors.

F. PRICING

Getting the pricing element of the marketing mix can be crucial to firms. If prices are set too low, a company may achieve good sales volumes, but end up making no profit from them. If on the other hand, prices are set too high, a company may sell very little of its product, resulting in surpluses and under-utilised production facilities. Getting pricing just right is a combination of an art and a science. We are assuming here that a firm has some degree of price leadership in its market – in other words, it is not operating in a perfectly competitive market in which prices are taken from the market. So, it is assumed that strategies to create differentiated products (for example by including additional features, or making the product more easily available to customers) are possible. Marketers must consider pricing not just at one point in time, but over the life of a product. A price based on differential advantage over competitors may need to change over time as competitors gradually erode a company's differential advantage. Strategic decisions about pricing cannot be made in isolation from other strategic marketing decisions, so, for example, a strategy that seeks a premium price position must be matched by a product development strategy that creates a superior product and a promotional strategy that establishes in buyers' minds the value that the product offers. There are three crucial questions that need to be asked when setting the price for any product:  How much does it cost us to make the product?  How much are competitors charging for a similar product?  What price are customers prepared to pay? We can also identify an additional factor that affects marketing managers in many public utility sectors:  How much will a government regulator allow us to charge customers? The relationship between these bases for pricing is shown in the diagram below.

High Maximum price Determined by what customers are prepared to pay.

SELLING PRICE Area of price Determined by direction competitive pressure/ consumer preferences.

Determined by what it costs the company to Low Minimum price produce.

Figure 7.5: The Relationship Between Price Bases

Cost-Based Pricing The cost of producing a product sets the minimum price that a company will be prepared to charge its customers. If a commercial company is not covering its costs with its prices, it cannot continue in business indefinitely (although many businesses appear to defy logic by continuing to make losses, perhaps for political or personal reasons). The principle of a direct link between costs and prices may be central to basic price theory, but marketing managers rarely find conditions to be so simple. It can be difficult to calculate the full costs of producing a product, especially where there are high levels of fixed costs. Sometimes, firms decide to base their pricing not on total costs, but only on marginal costs (that is, the extra costs incurred directly as a result of producing one additional unit of output). Marginal cost pricing is widely used in the travel industry to sell last minute spare capacity.

Competition-Based Pricing Very often, a marketing manager may go about setting prices by examining what competitors are charging. But who is the competition against which prices are to be compared? Competitors can be defined at different levels – those who are similar in terms of product characteristics or, more broadly, those who are only similar in terms of the needs which a product satisfies. As an example, a video rental shop can see its competition purely in terms of other video shops, or it could widen it to include cinemas and satellite television services, or wider still to include any form of entertainment. Companies often charge very competitive prices on products where knowledge of the going rate for that product among consumers is high. So, car repair garages may promote prices for a number of routine items such as a 12,000 mile service, but charge much more varying rates for specialised jobs. Supermarkets often promote a number of "loss leaders" (i.e. products which are sold at or below cost) where they know that these prices will create an impression among customers that the supermarket offers good value overall.

Demand-Based Pricing What customers are prepared to pay represents the upper limit to a company's pricing possibilities. In fact, different customers often put differing ceilings on the price that they are prepared to pay for a product. Successful demand-oriented pricing is therefore based on effective segmentation of markets and price discrimination which achieves the maximum price from each segment. Demand-based pricing can discriminate between customers on the basis of:  Demographic or socio-economic characteristics – for example, railcards for students or special lunch menus for senior citizens.  The time of purchase – this is especially important for services, where, for example, the cost of a telephone call varies according to the time of day.  The place of purchase – for example, many hotels charge different amounts at different locations. Many of the pricing principles discussed above, such as price discrimination and competitor- based pricing, may be quite alien to some public services. It may be difficult or undesirable to implement a straightforward price/value relationship with individual users of public services for a number of reasons. Firstly, external benefits may be generated by a public service for which it is difficult or impossible for the service provider to charge individual users. For example, road users within the UK are not generally charged directly for the benefits which they receive from the

© ABE and RRC 134 The Marketing Function road system, largely because of the impracticality of road pricing. Instead, road services are provided by direct and indirect taxation. Secondly, pricing can be actively used as a means of social policy. Subsidised prices are often used to favour particular groups, for example prescription charges favour the very ill and unemployed, among others. Sometimes, the interests of marketing orientation and social policy can overlap. Charging lower prices for unemployed people to enrol on learning courses at local colleges may provide social benefits for this group, while gaining additional revenue from a segment that might not otherwise have been able to afford such courses.

G. PROMOTION

The promotional mix includes all activities related to advertising, sales promotion, selling, public relations and direct marketing. Within each of these five categories a further range of options can be identified that can be used within the promotional plan. Figure 7.6 outlines some of the key elements of the promotional mix.

Advertising

Sales Promotion Promotional Integrated in Mix a campaign Public Relations

Direct Marketing

Figure 7.6: Key Elements of the Promotional Mix

We will explore briefly what each of these key elements of the promotional mix involves.

Advertising This is defined as: "any paid form of non-personal communication of ideas, goods or services delivered through selected media channels". Advertising encompasses a wide range of activities, from running adverts on prime time television through to placing a postcard in a newsagent's window. The term "media" is used to describe where the advert is placed. In addition to television and newspapers, magazines, outdoor posters and radio are commonly used media. There are also many less obvious and sometimes innovative media, such as adverts found on milk bottles and parking meters. The selection of media is critical. In an ideal world a specific advertisement would be seen and read by all of its intended target audience. In reality, however, such coverage is difficult to achieve. Different media are therefore selected to increase the probability of a member of the target audience seeing the advert at least once. The combination of types of media used for this purpose is often referred to as the "media mix". Advertising is defined as non-personal. Advertisements are targeted at a mass audience and not to a named individual. One of the benefits of advertising is therefore its ability to reach a large number of people at relatively low cost, although the total cost of a nationwide campaign may nevertheless be very high. If an advertiser wishes to reach a prime time

© ABE and RRC The Marketing Function 135 television audience or place a full page advert in a high quality magazine or newspaper, the costs will range from tens of thousands of pounds to hundreds of thousands of pounds just for one spot or insertion. However, this may still be much better value than a relatively low cost advertisement in a local newspaper in terms of the cost per 1,000 people in the target market who see it. With large audiences or readerships the cost of an advertisement per 1,000 viewers or readers can often fall to less than 10 pence.

Sales Promotion The Institute of Sales Promotion defines sales promotions as: "a range of tactical marketing techniques designed within a strategic marketing framework, to add value to a product or service in order to achieve a specific sales and marketing objective". Sales promotions can be targeted at consumers (with the aim of pulling sales through a channel of distribution), or at the distributor (with the aim of pushing products through the channel). The majority of people are familiar with, and have no doubt responded to, a sales promotion. The most common consumer sales promotion techniques include special offers, for instance price reductions or "two for the price of one" offers, competitions or gifts, coupons, or incentive schemes such as the promotion Coca-Cola ran in 2000 in which tokens from Coke cans could be redeemed against the cost of a Coca-Cola branded mobile phone. Sales promotions can also be targeted at retailers and wholesalers. Typical incentives include seasonal incentives to buy additional stock and bulk purchase offers. Traditionally, sales promotions have been used tactically to encourage brand switching, as a response to competitors' activity, or to create a short-term increase in the level and frequency of sales. Increasingly, sales promotions are now being used more strategically and integrated into an overall communications strategy. While price discounting, coupons and special offers still play an important part in the sales promotion mix, more attention is now being focused on how sales promotions can add value to a brand, rather than detracting from it.

Public Relations According to the Institute of Public Relations, PR is: "the deliberate, planned and sustained effort to establish and maintain mutual understanding between an organisation and its publics". In recent years there has been a significant increase in both interest and expenditure on public relations activity. Despite this interest and the work of the Institute of Public Relations to improve understanding, it still remains a misunderstood subject and fails to achieve the recognition and importance that it deserves. The key feature of public relations is its focus upon the "publics", or stakeholder groups that have an interest in, or can influence, an organisation's activities and positioning in its marketplace. These groups, such as trade unions, environmental pressure groups and merchant bankers are often united by a common interest or cause. Each group will have its own set of needs and agendas and will require careful monitoring and communication. As suggested in the definition, a key role of PR is to establish and maintain mutual understanding between the organisation and its key stakeholder groups. If the interests and issues raised by these groups are ignored or mishandled then the resulting publicity can do harm to the organisation's public image. Organisations such as the Body Shop and Virgin have in the past made extensive use of public relations activity to establish and reinforce their brands' credentials. Political parties are some of the more recent organisations to recognise the benefits of effective PR. Public relations typically encompasses the following types of activity:

 Media relations/press releases  Editorial and broadcast material  Publicity stunts  Sponsorship  Crisis management  Corporate image/corporate identity  Employee relations  Lobbying  Events management  Financial and corporate affairs

Direct Marketing Direct marketing can be defined as a "method of distributing products directly to customers , without the use of intermediaries such as wholesalers and retailers". It is one of the fastest growing means of distribution and can be achieved through a variety of methods such as:  Direct mail – This involves posting promotional materials to homes and businesses. Consumers often refer to these as "junk mail", but they can have distinct advantages – the communication can be personalised, market segments can be targeted and detailed information can be provided. Charities such as Oxfam, Save the Children and Greenpeace raise large funds by such methods.  Personal selling – This can be by means of door-to-door selling or, more commonly now, manned displays in retail outlets. Sales representatives can impart more detailed explanations of products and also answer consumer queries. It is common with firms supplying industrial markets.  Telephone selling – This is done by ringing people at home or at work and trying to sell a good or service. Although the seller can deal personally with the consumer, it is often felt to be an intrusive method by many customers.

The Message For the medium to work effectively, it must be used to convey an appropriate message. An advertising message must be able to move an individual along a path from being initially unaware of a product, through to becoming aware of it, and on to liking it and eventually purchasing it. In order for a message to be received and understood, it must gain attention, use a common language, arouse needs and suggest how these needs may be met. All of this should take place within the acceptable standards of the target audience. However, the product itself, the channel and the source of the communication also convey a message and therefore it is important that these do not conflict. Three aspects of a communication message can be identified as content, structure and format. It is the content which is likely to arouse and change attention, attitude and intention and therefore the theme of the message is important. The formulation of the message must include some kind of benefit, motivator, identification or reason why the audience should think or do something. Appeals can be rational, emotional or moral. Recipients of a message must see it as applying specifically to themselves and they must see some reason for being interested in it. The message must be structured according to the job it has to do and the points to be included in the message must be ordered (e.g. should the message start on an abstract note and then build up to the key point, or should it be hard hitting from the start?). Consideration should be given to whether one-sided or two-sided

© ABE and RRC The Marketing Function 137 messages should be used, and whether comparisons with competitors should be made (this can be quite dangerous, as there is evidence that merely mentioning the competitor can help raise their awareness, thereby helping individuals to move from being unaware to aware and eventually probably to liking and purchase). The actual format of the message will be influenced by the medium used, e.g. the type of print if published material, type of voice if broadcast media is used, etc.

Campaign Planning A promotional campaign brings together a wide range of media-related activities so that instead of being an isolated series of activities, they can act in a planned and co-ordinated way to achieve promotional objectives. The first stage of campaign planning is to have a clear understanding of promotional objectives (e.g. to gain awareness of a new product, to increase sales, to improve the public image of a product, etc.). Once these have been clarified, a message can be developed that is most likely to achieve these objectives. The next step is the production of the media plan. Having defined the target audience in terms of its size, location and media characteristics, media must be selected which achieve desired levels of exposure or repetition with the target audience. A media plan must be formulated which specifies:  The allocation of expenditure between the different media.  The selection of specific media components; for example, in the case of newspaper media, decisions need to be made regarding the type (tabloid versus broadsheet), the size of advertisement, which specific titles to use and whether there is to be national or local coverage.  The frequency and timing of insertions.  The cost of reaching a particular target group for each of the media vehicles specified in the plan. Many companies hand over much of the task of planning and managing their promotional campaigns to a specialist advertising agency. There are many benefits in giving the task to an outside agency. Many companies are too small to allow them to employ a specialist who is both creative in designing adverts and cost-effective in running an advertising campaign. The culture of an organisation, especially large ones operating in stable or regulated environments, may not be conducive to the creativity which advertising demands and therefore the latter may be better left to an outside organisation. It may also be easier for an outsider to be more customer-focused and see opportunities for promotion which are not immediately apparent to insiders who are too close to the product. A further major benefit of using an advertising agency is the ability to use their expertise in developing and executing advertising campaigns. They can usually purchase media on more favourable terms than a single company on its own. However, advertising agencies are sometimes accused of losing sight of the true nature of a product and its target customers. Agencies have frequently innovated in ways that have alienated their client which has subsequently had to disown a campaign.

H. DISTRIBUTION

Distribution (or "placing") of products involves the processes of getting goods or services from producers to consumers. Products must be made available in the right quantity, in the right location, and at the times when customers wish to purchase them, all at an acceptable price (and cost to the producer and/or intermediary). Achieving these aims is not easy but is often essential for an organisation wishing to gain a sustainable competitive advantage. Think of the times that you have tried to buy a product, such as a loaf of bread or an item of

© ABE and RRC 138 The Marketing Function clothing that is currently fashionable. Because the product was not immediately available, the chances are that you bought a competing product instead. Sometimes, a manufacturer will decide to dispense with intermediaries altogether. You may have noticed manufacturers of furniture, electrical goods and clothing advertising direct mail services "direct from the manufacturer". Many service organisations now have the capability to deal directly with their customers rather than acting through intermediaries. It makes sense for a company to distribute its own products directly where it can do a better job than outside intermediaries. In reality, companies use intermediaries because they are often a more cost-effective method of reaching target customers. Could you imagine the task facing Cadburys if it decided to deal directly with each of its millions of customers? Most purchasers of chocolate bars place a high value on ready accessibility and a manufacturer that did not make its chocolate available through tens of thousands of local shops would probably not achieve very many sales. Distribution is essentially about managing the channels through which products pass from the manufacturer to the final customer. A marketing channel can be defined as "a system of relationships existing among businesses that participate in the process of buying and selling products and services". Channel intermediaries are those organisations which facilitate the distribution of goods to the ultimate customer. The complex roles of intermediaries may include taking physical ownership of products, collecting payment and offering after-sales service. Since these activities can involve considerable risk and responsibility, it is clear that, in attempting to ensure the availability of their goods, producers must consider the needs of channel intermediaries as well as those of the end consumers. Distribution management refers to the choice and control of intermediaries, although, in reality, the ability of manufacturers to exert influence over intermediaries such as retailers varies considerably, especially in channels for FMCGs. Where retailers are powerful (as they are in the UK grocery sector), it is more often a case of intermediaries controlling the manufacturer rather than the other way round. The growth in supermarkets' market share remains unrelenting – by the mid-1990s, the top five UK multiples (e.g. supermarket chains, such as Tesco and Sainsbury's) accounted for over 60% of the total grocery market between them. In 1997, the proportion had reached over 80%. These changes have meant that it is vital for brand manufacturers to maintain good relations with their retail intermediaries in order to gain access to consumers. Various types of intermediary can participate in a supply chain. For most FMCGs, the two most commonly used intermediaries are wholesalers and retailers. These organisations are normally described as distributors (or "merchants") since they take title to products, typically building up stocks and thereby assuming risk, and reselling them (in other words, acting as wholesalers to other wholesalers and retailers, and retailers to the ultimate consumers). Other intermediaries, such as agents and brokers, do not take title to goods. Instead they arrange exchanges between buyers and sellers and in return receive commissions or fees. The use of agents often involves less of a financial and contractual commitment by the manufacturer and is therefore less of a risk, yet the lack of commitment to the manufacturer's goods from the agent may prove problematic.

I THE MARKETING MIX AND THE PRODUCT LIFE CYCLE

The marketing mix is the combination of factors through which a firm carries out its marketing strategy in order to encourage sales at each stage of the product's life. There are four aspects to the marketing mix: product, price, promotion and place. A different combination or emphasis is needed for each of these four factors at different stages of its life cycle.

For example, at the birth stage of a product the accent will be on product development as market research identifies any changes needed. Promotion will concentrate on developing product awareness among the identified target market. Pricing strategy will be either "skim" pricing if the product is seen as innovative or luxurious or "penetration" pricing in order to gain rapid market share. Initially the product will be "placed" in a limited geographical area or among a limited number of retail outlets in order to gain essential market feedback. Once the product reaches the growth stage the marketing mix will change. It will concentrate on developing widespread coverage with an expanded promotional campaign concentrating on the brand image and the use of a wider distribution network. Price may have to fall in the face of emerging competition as rival firms develop similar "me too" products or react by cutting the price of their existing products. Similarly at the mature stage the mix will change again as it seeks to encourage repeat sales from its loyal customers. Price discounts and special promotions may be used to hold on to market share and existing distributors. In the decline stage the firm can attempt to prolong the product's life through a series of "extension strategies". These may include developing a wider product range, entering new markets or changing the packaging. Once it is no longer profitable to continue production, advertising will cease and prices will be reduced to clear remaining stocks. The marketing mix is important, therefore, as it helps to support the product and to extend its sales at each stage of its life.

Study Unit 8 The Finance and Accounting Function

Contents Page

Introduction 143

A. The Basics of Business Finance 144 Finance and Types of Business Organisation 144 The Time Factor 144 The Cost of Finance 145

B. Sources of Finance 146 Retained Profits 146 Medium- and Long-Term Finance 146 Short-Term Finance 149

C. The Finance Providers 151 Clearing Banks 151 Merchant Banks 152 Venture Capital 152 Trade Suppliers 152

D. The Structure of an Organisation's Finance 152 Capital of a Company 152 Debentures 153 Gearing 155 Working Capital 156 Finance and Security 158

E. The Accounting Function 159 Accounting Requirements of the Companies Act 159 Users of Financial Statements 160 Financial and Management Accounting 161

F. Financial Accounts 162 The Profit and Loss Statement 163

(Continued over)

The Balance Sheet 165 Connections Between the Accounts 167 Stakeholder Perspectives 167

INTRODUCTION

Capital and finance are the lifeblood of any organisation so the finance function is of crucial importance. Finance permeates all the areas of an organisation. The finance function thus encompasses a range of important functions:  monitoring and controlling the state of all aspects of the financial situation;  advising the board of directors on financial matters;  raising capital as necessary;  preparing the accounts of the organisation, principally the balance sheet and profit and loss account;  controlling the inward and outward flow of cash;  providing detailed information for, and monitoring, all the budgets, ranging from master budgets for the whole organisation to departmental budgets;  liasing with the marketing department on such topics as pricing policies;  forward planning for the organisation, in respect of the financial implications of policies and strategies;  estimating future costs and profits;  dealing with all aspects of taxation and the auditing of company accounts. In this unit, we consider two particular aspects of this range of functions – the financing of the organisation through raising finance, and the reporting on the use of financial resources through the financial accounts. Objectives When you have completed this study unit you will be able to:  Identify the sources of finance available to different types of business enterprise and assess their suitability in respect of short-, medium- and long-term funding.  Be able to select the appropriate source of finance to match a business need and identify benefits and drawbacks of each type of finance.  Describe the main features of shares and debentures.  Define the concepts of gearing and working capital, and assess their implications for a company.  Identify the principal reasons for maintaining financial records and accounts, and describe the records that businesses must keep to fulfil legal requirements.  Identify the users of financial and accounting information, describe their requirements and explain their use of the data.  Describe the main elements of a business's profit and loss statement and balance sheet.  Describe and define the basic accounting terms.  Understand and calculate ratios to analyse business performance in relation to risk, liquidity and profitability.

A. THE BASICS OF BUSINESS FINANCE

Finance is a major issue for any business. There are very few business organisations which can get by purely on the revenue they receive from sales of goods and services – not least because of the time lag between paying for the factors of production (raw materials, labour, capital) and the receipt of funds for the final product. When organisations wish to expand their operations, the need for additional finance is obvious. The key question, then, is: what are the options available for raising funds? There are, basically two methods:  borrowing – taking out a loan of some sort from, usually, a financial institution such as a bank; or  extending the ownership of the business by getting new owners (or getting the existing owners to put in more money). Before we go on to look at the major finance packages available under these two general headings, there are a few basic points to be clear about which affect the options open to a business.

Finance and Types of Business Organisation First we need to recall the importance of the types of business organisation as they relate to the raising of finance. You will remember that business organisations come in all shapes and sizes, but there is a key distinction between:  unincorporated businesses – principally sole traders and partnerships where there is no legal distinction between the owners and their business, and the personal assets of the business owners and the assets of the business are treated as one.  incorporated businesses – where the business owners and the business itself are legally separate, with the personal assets of the owners being treated as distinct from the business assets they own. This is the case with private limited companies and public limited companies. The owners of incorporated businesses are shareholders in that business. Ownership is spread among, possibly, a very large number of individuals, each of which owns only a proportion of the business, as defined by the number of shares held. Shareholders enjoy limited liability – limited to their shareholding. This means that should an incorporated business run into financial difficulties and not be able to pay its debts, the creditors (those owed money by the business) cannot ask the owners of that business for anything over and above their shareholding. The company is liable to the extent of its business assets, but the owners are only liable for their stake in the company. They stand to lose their investment in the shares, but nothing further. This means that raising finance from shareholders is easier, since those investing in the business have less to lose – there is less risk.

The Time Factor Businesses need funds for different time periods. These time periods are generally classified as:  short term – usually taken to mean under one year, tying in with the accounting year;  medium term – usually taken to mean between one and five years;  long term – usually referring to finance for over five years. It is generally accepted that the term of the finance should be linked to the purpose for which the finance is required. For example, if a business wanted to buy a consignment of stock for

© ABE and RRC The Finance and Accounting Function 145 resale within six months, then short-term finance would be appropriate. It would not make sense to take out a 25-year loan to finance a transaction which only needs cover for six months. However, other purposes, such as buying new machinery, will call for long-term finance. If the machinery is expected to be operational for eight years, it would be wise to arrange finance for a similar period so that the earnings from the machine match the finance for it. Business requires a mix of finance to meet its various requirements and larger firms will have a range of financial arrangements over the short, medium and long term.

The Cost of Finance If a business wants to raise funds, for whatever reason, it is asking someone – the existing owner, new owners or an outside body – to put their own money into it. Anyone investing will want a return of some sort on the money provided for the business, so raising finance necessarily involves a cost to that business. In the case of borrowed funds, this will be in the form of the rate of interest payable on the loan. As long as the loan remains unpaid, interest charges are due and will have to be paid out of the business's income. This can be a serious matter if a business has substantial loan debts. Interest rates are always expressed as a particular % rate per year, regardless of how long the loan is for. Thus, a loan of £1,000 for one year at an interest rate of 12% would mean that the business must repay £1,120 at the end of the year – the sum borrowed plus interest. The borrower has full use of the £1,000 for the whole year and does not need to repay any of it until the year has elapsed. If a business wants to borrow funds, it may have to offer some form of security to the lender. The point of security is that, if the business fails to repay the loan, the lender is entitled to take ownership of the security and sell it to recover the money owed. The security offered by the business will take the form of a business asset, such as stock or buildings owned by the organisation. However, it is clear that not all assets are going to be suitable as security and if the business does not have sufficient suitable assets to offer as security, the lender may ask the owners of the business to give their personal guarantees for the loan. Thus, the owners may have to, for example, put up personal property as security against the loan not being repaid. The owners of a business will expect a return on their personal investment in the business in the form of a share of the profits. Thus, extending ownership of the business by inviting new investors to put money into it, or getting the existing owners to invest more of their personal money, means that a larger share of the profits will need to be paid out to the owners. However, with equity finance, importantly, there is no commitment by the business to pay any return at all. If the business makes no profit, it is not obliged to pay anything to the shareholders. Nor can the shareholders require the business to buy back their shares – the only way a shareholder can liquidate shares (turn them into cash) is to sell them to someone else. Shares are, therefore, permanent funds for a business. (Note that there is an important difference between a private limited company and a PLC in that the shares of PLCs can be freely sold. The markets where sellers and buyers can trade shares are the stock markets. The shares of limited companies, however, cannot be freely sold. One consequence of this is that PLCs can offer shares to the general public whereas limited companies cannot.)

B. SOURCES OF FINANCE

In this section we shall survey the major finance packages available to a business. These vary with the length of time over which the finance is required and we shall examine them in relation to the medium- to long-term options and then the short-term possibilities. First, however, we need to consider one option which does not involve actually raising finance from outside the existing business.

Retained Profits When a business makes a profit, a proportion will generally be paid out to the owners – in the form of drawings in the case of sole traders and partnerships or dividends on shares in the case of limited companies and PLCs. The rest of the profit will be retained in the business and can be used to finance its growth in the form of new investment in plant and machinery. As we have seen, there is no obligation on a company to pay out a particular amount as a dividend or even to make such payments to shareholders at all. For sole traders and partnerships, the owners may be willing to forego any drawings in the interest of ploughing back the profits into the business in the expectation that further profits will be forthcoming in the future. Thus, retaining profits represents an important option for a business seeking additional funds. In practice, for unincorporated businesses and limited companies, retained profits are the main source of finance over both the short and long term. If these businesses are to grow, then they must earn profit and retain much of it in the business.

Medium- and Long-Term Finance In the medium and long term, businesses are concerned with growth and/or consolidation. They will want finance to fund expansion by acquiring more assets or increasing the factors of production that they can bring to bear as inputs into the business. Consolidation will invariably involve replacing assets as they reach the end of their useful life as well as developing the use to which existing factors of production may be put – for example, through investment in training the workforce. The options for financing this are as follows.  Share issues This option is only available to PLCs. They can offer new shares to the investing public. Investors are invited to put money into the company in return for (possible) future dividends and the possession of a stake in the company which can be sold if required. The return on the investment may be seen as both the dividend and any increase in the share price. In some cases businesses will offer the new shares only to existing shareholders. This is known as a rights issue. Shareholders are not obliged to buy the new shares, but there can be strong reasons for doing so. The success of a share issue depends on the growth and profit track record of the issuing company as well as the market conditions prevailing at the time. Timing can be very important. As such, share issues are normally carried out through a merchant bank intermediary who will have the expertise to handle them (which a PLC will not generally have). (We shall consider shares in more detail later in the unit.)

 Loan stock As an alternative to making a share issue, a PLC can issue loan stock. The purchasers of this stock will not become shareholders, but will be creditors. They have lent their money to the business and expect to receive regular interest payments and eventually their money back when the loan stock matures. The very best companies will not usually have to offer any security against their loan stock issue – their track record of success is all the security that is necessary. However, others may have to put up assets as security and run the risk of not getting any takers at all, depending on the attractiveness of the security.  Debentures Debentures are another form of loan. They are, in effect, a loan contract taken out with a lender (for example, a bank). Again, the lender is not an owner, but a creditor with the business borrowing the money undertaking to pay interest on a regular basis and to repay the loan at the agreed time. Debentures are generally secured on the assets of the business, which means that debenture holders have first call on those assets should the company not be able to meet its obligations to pay interest or repay the loan. This option is available to both limited companies and PLCs. (We shall consider debentures in more detail later in the unit.)  Leasing If a business needs assets – such as a new computer system or fleet of vehicles – it has the choice of buying them outright or leasing them. In practice, leasing is a form of hire under which the business has the use of the computers or vehicles for an agreed period. The business leasing the assets is obliged to look after maintenance. Leasing is particularly advantageous in situations of uncertainty or where the business is not willing to commit large capital sums to buy assets. It can also make sense where technology changes rapidly and a business needs to update its equipment regularly. Further, leasing can have tax advantages for both the business leasing the assets and the lessor. Leasing is available to all types of business. In some cases, there may be an option to buy the assets at the end of the lease. This arrangement is called lease/purchase.  Commercial mortgages Some companies may own the freehold of real estate premises in the form of factories, office accommodation or warehouses. As we shall see later, these assets will have a value in the company's accounts. If the business wants to raise a capital sum for investment in new assets, it could take out a commercial mortgage with a property company. Normally the maximum mortgage will be between 60% and 70% of the property value. The premises themselves are used as security, and the mortgage loan will usually be for the long term. The advantage of this arrangement is that the business can continue to use the premises as before, but must service the commercial mortgage in terms of interest payments and eventually repay the capital sum. Another plus is that any increase in property values over time still belongs to the business and not the property company to which it has been mortgaged.

 Asset sales All businesses own certain assets – computers, vehicles, machinery, etc. Their value is also recorded in the accounts – under the general heading of fixed assets. Where such capital assets are surplus to the business's requirements, one option is to sell them and convert them into cash which can be used to purchase new assets or to repay debts, etc.  Sale and leaseback This option relates to real estate assets. Where a business owns premises and needs to raise finance, it may sell the freehold and simultaneously arrange to lease it back. The business converts the real estate fixed asset into cash, but will continue to be able to use the property as before. Such arrangements are generally very long term to guarantee the continued availability of the asset to the organisation. The advantage of this method, compared to the commercial mortgage option, is that 100% of the freehold value is realised, which is higher than is possible with a mortgage. However, on the other hand, the business will not enjoy any future increase in the property's market value. Sale and leaseback may also be possible for certain types of capital equipment, such as large machinery.  Bank loans All the major banks offer a range of business loans. They range from a few months to up to 25 years. Some loans are at a fixed rate of interest which is agreed at the start of the loan period and applied throughout the period of the loan. Other types of loan may have a variable rate of interest. Here, the interest rate will fluctuate over the period of the loan in line with interest rates in the economy. Banks will usually tailor a loan package to suit the requirements of individual businesses and will also carry out a risk assessment on the business before going ahead with the loan. Depending upon the outcome of the risk assessment, the lender will normally require some form of security (either business or personal assets) to guarantee the loan and may require the business to issue a debenture to the bank. From the point of view of the business, there will be the need to meet interest payments and make provision to repay the loan itself.  Grants Governments will provide financial support to business in certain circumstances. The circumstances vary and, in any case, an individual government's policies may be constrained by wider considerations – for example, the UK government's policies must not contravene European Union rules. The major grants are related to regional policy. There will always be some regions of a country which lag behind others in terms of employment and living standards, for example due to the predominant industry in the region being in decline. Businesses which locate in these regions may get grants, especially related to investment, and even existing businesses that threaten to move out may get grants. There are usually conditions attached to grants, including guarantees of continued business and the creation of jobs. The main attraction of grants is that they constitute free finance – there are no interest charges or repayments of capital.

Short-Term Finance Short term refers to finance for twelve months or less. It is normally required to tide a business over periods when income will not be sufficient to cover outgoings and the business needs funds which can be repaid as soon as the position reverses. Short-term finance would not normally be used to fund expansion or consolidation. The main options for short-term financing are as follows.  Bank loans These have already been mentioned in the previous section. It is important to remember that bank loans can also be short term. Similar conditions apply.  Bank overdraft All businesses have bank accounts. If a business is experiencing cash flow problems, an overdraft could be an answer. Cash flow problems are common in business and arise because production invariably occurs before sales. Therefore, a business finds itself paying out production costs before any revenues come in from sales. A simple example will illustrate the problem. Consider the situation of a business producing and selling at a constant rate, but not receiving any revenue from sales for the first two months of the year. Production costs are £4,000 per month and the goods produced each month are sold for £6,000. The cash flow position is set out in the following table.

Jan Feb Mar Apr May Jun Jul

Revenues (sales) (£) 0 0 6,000 6,000 6,000 6,000 6,000 Payments (costs) (£) 4,000 4,000 4,000 4,000 4,000 4,000 4,000 Monthly net cash (£) 4,000 4,000 2,000 2,000 2,000 2,000 2,000 (sales less costs) Cumulative (£) 4,000 8,000 6,000 4,000 2,000 0 2,000 balance

This is a very simple example, but it does bring out the key issues. The business pays out £4,000 a month in costs to make its product. Sales are made in January, but the business does not actually get paid for these until March. At the end of January, there is a cash deficit of £4,000 which is carried over into February when another £4,000 deficit occurs. This carries the overall cumulative balance to a deficit of £8,000. In the next month, £6,000 cash comes in, but there is still £4,000's worth of payments to make. While there is now a surplus of £2,000 this only helps to bring the cumulative balance deficit down to £6,000 from the £8,000 at the end of February. The rest of the figures should be easy to follow. The business only appears to get into a balanced situation in June when the cumulative deficit gets wiped out. A business making its forecasts and coming up with these figures would conclude that it is not viable in the short term, even though it moves into profit by the end of the year. In order to reap the profits forecast for the end of the year, it needs some short-term finance to tide it over while the cash flows are negative. How else can it pay £4,000 in January if there is no cash coming in?

In such situations, an overdraft facility provides the best option. The business effectively needs a flexible short-term loan which will enable it access to the necessary funds as it needs them, but does not involve raising all the finance necessary at one time and then paying interest on the whole amount over the period. In this case, the business needs access to sums up to £8,000, but by the end of June it should be able to pay it all back altogether. Under the terms of an overdraft, a bank will usually only charge interest on the amount by which the account is actually overdrawn. So in March, the business will be charged one month's interest on £6,000 and not on the full £8,000 overdraft facility. The interest charged is always the current rate. If, say, interest rates in the economy rise at the end of February, the business will be charged the higher rate on its March overdraft of £6,000 (although, if the rate falls, the lower rate will be applied). One problem with an overdraft is that the bank can ask for it to be cleared in full at any time. In practice, this will not often happen. However, if the bank's risk assessment of the business deteriorates, then the business might be asked to clear its overdraft.  Invoice factoring Invoice factoring is an alternative to an overdraft in situations where there is always a time lag between the issuing of invoices and the receipt of payments, resulting in a cash flow problem for the business. In the simple cash flow example above, the business is making sales in January but is getting no cash payment for them until March. In effect, the business is allowing customers 60 days' credit. It may well be that this is necessary in order to get the sales in the first place. The way in which factoring works is illustrated in Figure 8.1.

Selling Company 1 Buying Company

2 Factoring Company 3

Figure 8.1: Invoice Factoring

The selling company sells to the buying company and invoices in the normal way (1) and for the normal credit terms of 60 days. A copy invoice is sent to the factoring company. When it receives the invoice, the factoring company will pay 80% of the invoice value to the selling company (2). In the example above, the selling company would send out £6,000 of invoices in January and will get 80% of this (i.e. £4,800) immediately. In 60 days' time, the buying company makes its payment, but sends it to the factoring company (3) and not to the selling company. When the factor receives payment, it sends the 20% balance to its client, the selling company. The factoring company makes its money by charging its client a percentage of the value of the invoices it has factored. This is usually done on a monthly basis. To the selling company, this represents the cost of balancing cash flow to the issuing of invoices on a credit basis. If a particular customer fails to pay – perhaps because it has gone into liquidation – the factoring company cannot reclaim the 80% it has already paid to its client. This is

known as non recourse factoring. Because of this, factoring companies always examine the credit track record of "customer" companies. If a particular company's credit rating gives cause for concern, the factor will simply inform its client business that it will not factor invoices to that particular company. Invoice factoring can be seen as an alternative to an overdraft for a business. Businesses will look at the comparative costs of both before deciding which facility to choose.  Trade credit Another possible solution to the short run cash flow problem is to try to find ways of delaying payments to suppliers. To achieve this, a business will try to negotiate trade credit terms with its suppliers. Before being allowed such credit, a new business is likely to have to establish a credit track record by paying cash with orders for some time. When trade credit terms can be arranged, the business can order materials from suppliers and perhaps process them into finished goods for sale before it has to pay for them. Obviously, if trade credit can be arranged, then some payments can be delayed. It is possible to see that if, say, 50% of payments in the cash flow statement above could be deferred, it would reduce the overdraft requirement very substantially. The major advantage of trade credit is that it is interest free. Some suppliers who give trade credit will also offer cash discounts to buyers who pay early.  Customer prepayments Generally, customers will not be prepared to pay until they have received the goods or services they are buying. However, there are some situations where customers can be persuaded to pay at least something in advance. Examples include health clubs and tour operators

C. THE FINANCE PROVIDERS

Having looked at the main finance packages, we will now look briefly at the main providers of them.

Clearing Banks All businesses will have a bank account – possibly a considerable number of different accounts, depending on the nature of the business. As the main financial institution with which a business is connected, the bank is invariably the first stop in the search for finance. All banks provide overdraft and loan facilities. The clearing banks are the large high street banks. In practice, it is more useful to think of them as financial service providers. They are very large public limited companies in their own right and have shareholders to satisfy and are in the business of selling financial services to generate maximum profits for their owners. As such, most of the invoice factoring companies and leasing companies are owned by the main banks. Thus, the banks are in competition with each other to sell those services to businesses and companies seeking to raise finance have the opportunity to compare costs before deciding which particular financing option to take up with which bank.

Merchant Banks Merchant banks are very different from high street banks – they are essentially wholesalers (dealing direct with businesses) as opposed to being retailers, although most of the clearing banks have merchant banking divisions. PLCs who want to raise funds by making share issues or issues of loan stock will usually hire the services of a merchant bank. PLCs only rarely make an issue and, therefore, are unlikely to have the expertise in-house to do the job themselves. Merchant banks offer both that expertise, and contacts among the large investors in the City. Most of the large investment funds available to invest in business enterprises are held by institutional investors – including insurance companies, pension funds, investment trusts and unit trusts – rather than private individuals. These institutions employ professional fund managers who look for suitable investment opportunities, including shares and loan stock issues. They work closely with the merchant banks. Merchant banks can advise PLCs on such matters as timing and placing of the issue as well as the best price to sell at. They will also usually undertake (for a fee) to handle the entire issues process and will underwrite the issue. What this means is that, if the issue is not fully sold to investors, the merchant bank itself will buy the unsold balance. The PLC is, therefore, guaranteed a minimum sum of money to be raised from the issue. The bank will try to dispose of the rest on the market at a later time. In addition to this service, merchant banks are also prepared to advise companies about potential takeover targets or to offer help if a business itself becomes a target for takeover.

Venture Capital Some businesses will find it difficult to raise money through the conventional channels. In particular, high-tech businesses, dot.com companies (especially in the light of the collapses of many such companies in the early 2000s) or firms with highly innovative products may fall into this category. In the last 20 or so years a group of venture capital companies have emerged. They attract funds from high income tax investors (who can claim tax relief) and are prepared to undertake high risk investment in return for high potential returns. They are prepared to take a stake in high risk companies in the form of either loan capital or equity. They may want representation on the boards of the companies in which they are investing in order to influence policy.

Trade Suppliers The other main suppliers of business finance are trade suppliers. It should be borne in mind that suppliers are businesses and may be looking for finance themselves so that they can offer trade credit to their customers.

D. THE STRUCTURE OF AN ORGANISATION'S FINANCE

Capital of a Company Virtually every business must have capital subscribed by its proprietors to enable it to operate. In the case of a partnership, the partners contribute capital up to agreed amounts which are credited to their accounts and are treated as liabilities of the business. A limited company obtains its capital, up to the amount it is authorised to issue, from its members. A public company, on coming into existence, issues a prospectus inviting the public to subscribe for shares. The prospectus advertises the objects and prospects of the company in the most tempting manner possible and it is then up to the public to decide

© ABE and RRC The Finance and Accounting Function 153 whether they wish to apply for shares. As we have seen, the process of issuing shares will be undertaken by a merchant bank which will arrange for the issue to be underwritten and may also be instrumental in bringing in institutional investors. A private company is not allowed to issue a prospectus and obtains its capital by means of personal introductions made by the promoters. Once the capital has been obtained, it is lumped together in one sum and credited to a share capital account. This account does not show how many shares were subscribed by A or B – such information is given in the register of members, which is a statutory book that all companies must keep. From the point of view of the company the capital as a whole is its source of funds. This capital has certain distinctive features:  Once it has been introduced into the company, it generally cannot be repaid to the shareholders (although the shares may change hands). An exception to this is redeemable shares.  Each share has a stated nominal (sometimes called par) value. This can be regarded as the lowest price at which the share can be issued.  Share capital of a company may be divided into various classes, and the Articles of Association define the respective rights of the various shares as regards, for example, entitlement to dividends or voting at company meetings. Types of share (a) Ordinary shares The holder of ordinary shares in a limited company possesses no special right other than the ordinary right of every shareholder to participate in any available profits. If no dividend is declared for a particular year, the holder of ordinary shares receives no return on his shares for that year. On the other hand, in a year of high profits he or she may receive a much higher rate of dividend than other classes of shareholders. Ordinary shares are often called equity share capital or just equities. (b) Preference shares Holders of preference shares are entitled to a prior claim, usually at a fixed rate, on any profits available for dividend. Thus, when profits are small, preference shareholders must first receive their dividend at the fixed rate per cent, and any surplus may then be available for a dividend on the ordinary shares – the rate per cent depending, of course, on the amount of profit available. So, as long as the business is making a reasonable profit, a preference shareholder is sure of a fixed return each year on his or her investment. The holder of ordinary shares may receive a very low dividend in one year and a much higher one in another. Rights issues As we have seen, a useful method of raising fresh capital is first to offer new shares to existing shareholders, at something less than the current market price of the share (provided that this is higher than the nominal value). This is a rights issue, and it is normally based on number of shares held, as with a bonus issue – for example, one for ten. In this case, however, there is no obligation on the part of the existing shareholder to take advantage of the rights offer, but if he/she does, the shares have to be paid for.

Debentures A debenture is written acknowledgment of a loan to a company, given under the company's seal, which carries a fixed rate of interest.

Debentures are not part of the capital of a company. Interest payable to debenture holders must be paid as a matter of right and is, therefore, classified as loan interest – a financial expense – in the profit and loss account. A shareholder, on the other hand, is only paid a dividend on his investment if the company makes a profit, and such a dividend, if paid, is an appropriation of profit. There are three types of debenture:  Simple or naked debentures – These are debentures for which no security has been arranged as regards payment of interest or repayment of principal.  Mortgage or fully secured debentures – Debentures of this type are secured by a specific mortgage of certain fixed assets of the company.  Floating debentures – Debentures of this type are secured by a floating charge on the property of the company. This charge permits the company to deal with any of its assets in the ordinary course of its business, unless and until the charge becomes fixed or crystallised. An example should make clear the difference between a mortgage, which is a fixed charge over some specified asset, and a debenture, which is secured by a floating charge. Suppose that a company has factories in London, Manchester and Glasgow. The company may borrow money by issuing debentures with a fixed charge over the Glasgow factory. As long as the loan remains unpaid, the company's use of the Glasgow factory is restricted by the mortgage. The company might wish to sell some of the buildings, but the charge on the property as a whole would be a hindrance. On the other hand, if it issued floating debentures then there is no charge on any specific part of the assets of the company and, unless and until the company becomes insolvent, there is no restriction on the company acting freely in connection with any of its property. The rights of debenture holders are:  They are entitled to payment of interest at the agreed rate.  They are entitled to be repaid on expiry of the terms of the debenture as fixed by deed.  In the event of the company failing to pay the interest due to them or should they have reason to suppose that the assets upon which their loan is secured are in jeopardy, they may cause a receiver to be appointed. The receiver has power to sell a company's assets in order to satisfy all claims of the debenture holders. The differences between shareholders and debenture holders are summarised in the following table:

Shareholder Debenture Holder

In effect, one of the proprietors A loan creditor and therefore an – i.e. an inside person. outside person. Participates in the profits of the Secures interest at a fixed rate company, receiving a dividend on his or her loan to the on his or her investment. company, notwithstanding that the company makes no profit. Not entitled to receive Entitled to be repaid on expiry repayment of money invested of term of debentures as fixed (with certain exceptions) unless by deed, unless they are the company is wound up. irredeemable debentures.

Gearing The gearing of a company refers to the balance between owners' funds and borrowed funds. More strictly, it is the proportion of loan finance to total capital employed, or the ratio of fixed- interest and fixed-dividend capital (i.e. debentures plus preference shares) to ordinary (equity) share capital plus reserves. The issue of a company's gearing can have important repercussions, as debenture interest must be paid regardless of profitability. The sources of finance used by companies to raise funds will, therefore, be affected by its current gearing. An example should help to clarify this. Suppose we take two companies, A and B:

A B

Share capital 100,000 180,000 Loan capital 120,000 40,000

Total capital 220,000 220,000

Both businesses have the same capital employed of £220,000 but the make up of that capital is very different: Company A has £120,000 in loan capital out of a total of £220,000 – i.e. 54%. Company B has only £40,000 in loan capital out of a total capital of £220,000 – i.e. 18%. These percentage figures are known as gearing ratios. Company A would be described as a relatively highly geared compared with Company B. Company B is relatively low geared. High gearing can make a business more vulnerable to changes in its income. Remember that interest must be paid on loans whatever situation the business is in. Thus, even if sales collapse and profits vanish, interest payments still have to be met. We can illustrate this through looking at the effects of different levels of profit on the two companies above. If we assume that the interest rate applicable is 12%, then Company A will have to pay £14,400 interest each year on its loan capital, whereas Company B only has to pay £4,800 each year. The effect of this is as follows:

A B

Net profit 20,000 20,000 less Interest 14,400 4,800

Available for shareholders 5,600 15,200

Net profit is what is left of the business's sales revenue after all costs have been deducted. In the case of A, £14,400 of this is needed to meet interest payments leaving £5,600 for equity holders (shareholders). B's situation, with the same profit, is that £4,800 is required for interest and £15,200 is left for shareholders. Suppose that, next year, profits fall to £14,000 for both companies. The situation will be as follows:

A B

Net profit 14,000 14,000 less Interest 14,400 4,800

Available for shareholders 400 9,200

Company A is now unable to pay its interest charges from current profits and must use £400 of its reserves meaning that shareholders lose £400 of their equity. B is still able to meet its interest charges from profit and leave something to increase shareholder equity. Sales and profits do vary for a number of reasons and certain types of business are especially vulnerable to this and in potential danger if they are highly geared. This particularly applies to those firms whose sales and profits are cyclical, such as construction firms. Other businesses, such as food retailers, are far less affected and can afford to be more highly geared. The most obvious implication from this is that it is not sufficient just to estimate how much capital a business might need; you also need to consider the nature of the business and the mix of loan and equity which might be best in the circumstances.

Working Capital At the shorter end of the time scale, there is another concept which is important to the financial structure of the firm. Working capital is defined as current assets less current liabilities, and represents a measure of the ability of the company to pay its way. It is usual to consider working capital in the context of a cycle of business activities. When a business begins to operate, cash will initially be provided by the proprietor or shareholders. This cash is then used to purchase fixed assets (machinery, etc.), with part being held to buy stocks of materials and to pay employees' wages. This finances the setting-up of the business to produce goods/services to sell to customers for cash, which sooner or later is received back by the business and used to purchase further materials, pay wages, etc.; and so the process is repeated. The cycle is illustrated in Figure 8.2.

Cash Expenses incurred with suppliers/employees

Cash from debtors

Cash to creditors

Debtors Goods/services produced Stock

Figure 8.2: The Working Capital Cycle

Problems arise when, at any given time in the cycle, there is insufficient cash to pay creditors, who could have the business placed in liquidation if payment of debts is not received. One solution would be for the business to borrow to overcome the cash shortage,

© ABE and RRC The Finance and Accounting Function 157 but this can be costly in terms of interest payments, even if a bank is prepared to grant a loan. A more appropriate response would be to strike a balance between assets and liabilities such that there is sufficient working capital and liabilities are always covered. Working capital requirements can fluctuate because of seasonal business variations, interruption to normal trading conditions, or external influences, such as changes in interest or tax rates. Unless the business has sufficient working capital available to cope with these fluctuations, expensive loans become necessary; otherwise insolvency may result. On the other hand, the situation may arise where a business has too much working capital tied up in idle stocks or with large debtors which could lose interest and therefore reduce profits. Irrespective of the method used for financing fixed and current assets, it is extremely important to ensure that there is sufficient working capital at all times and that this is not excessive. If working capital is in short supply, the fixed assets cannot be employed as effectively as is required to earn maximum profits. Conversely, if the working capital is too high, too much money is being locked up in stocks and other current assets. Possibly, the excessive working capital will have been built up at the sacrifice of fixed assets. If this is so, there will be a tendency for low efficiency to persist, with the inevitable running down of profits. The management of working capital is an extremely important function in a business. It is mainly a balancing process between the cost of holding current assets and the risks associated with holding very small or zero amounts of them. The issues involved in respect of the different current assets are as follows. (a) Management of stocks which may include raw materials, work-in-progress (both in a manufacturing business) and finished goods. We have considered the costs of holding and of not holding stocks in a previous unit, but we repeat them briefly here.  The cost of holding stocks: (i) Financing costs – the cost of producing funds to acquire the stock held (ii) Storage costs (iii) Insurance costs (iv) Cost of losses as a result of theft, damage, etc. (v) Obsolescence cost and deterioration costs These costs can be considerable, and estimates suggest they can be between 20% and 100% per annum of the value of the stock held.  The cost of holding very low (or zero) stocks: (i) Cost of loss of customer goodwill if stocks not available (ii) Ordering costs – low stock levels are usually associated with higher ordering costs than bulk purchases (iii) Cost of production hold-ups owing to insufficient stocks The organisation will set the balance which achieves the minimum total cost, and arrive at optimal stock levels. (b) Management of debtors requires identification and balancing of the following costs:  Costs of allowing credit: (i) Financing costs (ii) Cost of maintaining debtors' accounting records (iii) Cost of collecting the debts

(iv) Cost of bad debts written off (v) Cost of obtaining a credit reference (vi) Inflation cost – outstanding debts in periods of high inflation will lose value in terms of purchasing power  Cost of refusing credit: (i) Loss of customer goodwill (ii) Security costs owing to increased cash collection Again, the organisation will attempt to balance the two categories of costs – although this is not an easy task, as costs are often difficult to quantify. It is normal practice to establish credit limits for individual debtors. (c) Management of cash. Again, two categories of cost need to be balanced:  Costs of holding cash: (i) Loss of interest if cash were invested (ii) Loss of purchasing power during times of high inflation (iii) Security and insurance costs  Costs of not holding cash: (i) Cost of inability to meet bills as they fall due (ii) Cost of lost opportunities for special-offer purchases (iii) Cost of borrowing to obtain cash to meet unexpected demands Once again, the organisation must balance these costs to arrive at an optimal level of cash to hold. The technique of cash budgeting is of great help in cash management. It is quite possible for a firm to go out of business because of working capital problems. The business may have a good product, effective production systems and so on, but be unable to manage its short-term working capital cycle.

Finance and Security One final issue needs to be examined briefly and that is the question of security. In most cases, lenders will want some sort of security from a borrower. All lending involves risk, and security is designed to reduce the lender's risk. If the business cannot repay the loan or keep up interest payments, the lender can seize the security and sell it to recover the loan. In one sense, if this happens, it means that the lender may have made a mistake in lending to the business in the first place. Something has gone wrong with the risk assessment process. The whole purpose of risk assessment is that the lender wants to know if the borrower is likely to repay any loan. Security, then, is simply a form of insurance should the assessment go wrong. What makes effective security? Not all assets are good security. For an asset to be good security it must have a number of features:  there should be an organised market for the type of asset involved in case it needs to be sold;  the value of the asset should be something which can be calculated;  the asset's value should not be subject to big changes over the loan period.

Business assets which meet these criteria include buildings and stock. However, if the business itself does not have sufficient value of security to back the loan, the personal assets of the business owners might fill the gap.

E. THE ACCOUNTING FUNCTION

Accounting is the presentation of information concerning the financial activities of the enterprise. In the modern business, though, the accounting function is not solely concerned with recording that information and setting it out in particular accounts. It is concerned with providing information, expressed in monetary terms, which will assist the whole of the enterprise in achieving its chosen objectives, in the following ways:  By looking at past actions and building on past experience.  By projecting into the future to see the likely effect of following a certain course of action. There are various groups of people (including the management or owners) who want or need information about a business. We will look at these different groups shortly, but in order to be able to meet the information needs of these groups, an accounting system has to be in operation to produce information which is both reliable and accurate. The most basic information required will cover:  Whether the business is making a profit.  What assets the business owns.  What the business owes, and what is owed to the business. The accounting system will usually provide much more information than this, and when you study accounting elsewhere in your course, you should begin to appreciate that the accounting system is a principal tool of management in planning and controlling future business activities. As well as recording and analysing the transactions of a business in order to provide information to the various user groups, there are also some legal requirements to prepare financial statements; for example, requirements in the Companies Act 2006. In addition, Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs) exist, requiring companies to prepare accounts conforming to particular requirements.

Accounting Requirements of the Companies Act There is great formality about the records which companies must maintain as compared with, say, the self-employed plumber or a partnership of two or three builders. Nevertheless, all businesses must keep records for tax purposes in accordance with statutes. A company must keep accounting records which are sufficient to give a clear indication of its financial position at any time. The accounting records must be kept for three years in the case of a private company, or six years otherwise, and they must show:  Daily records of receipts and payments of moneys  Details of assets and liabilities  Stocktaking records at the end of the financial year  With the exception of retail sales, clear indications of identities of the purchasers and sellers of goods, as well as of the actual goods themselves. From the above records, the following must be prepared at specific intervals:

 A profit and loss account (or an income and expenditure account, if appropriate)  A balance sheet (as at the date of the end of the period covered by the profit and loss account)  An auditors' report (although there are exemptions for small companies where accounts need not be audited)  A directors' report  Group accounts (if applicable). Income and expenditure accounts are usually prepared by clubs, societies, etc., the main object of which is not the earning of profits.

Users of Financial Statements There are numerous groups who may be interested in the financial statements of a company.  The owners (proprietor, partners or shareholders) will wish to know how well the business is doing in order to ascertain how much money they can withdraw for their own purposes. Shareholders are interested in their investment in the company and therefore they require information on the company's profitability and the amount of dividend to be distributed. Additionally they need to know about the company's stability, liquidity and growth.  The management of a business need up-to-date information about the financial situation to enable them to assess how efficiently the business is being run, whether objectives are being met, and also to aid them in their planning and control decisions. (Note that in a small company the owners and management may be the same people.)  Employees also need information about the business as the security of their employment depends upon the financial state of the business. They require an evaluation of the company's performance in order to assess the profitability and liquidity, and thus the company's ability to meet wage increases. They are also interested in the future prospects for growth, new products etc., to establish the company's intentions on employment levels.  Trade creditors require information on the company's ability to pay its bills and thus need details on its liquidity.  Suppliers will want to assess whether the enterprise can be given credit and to forecast whether its expected growth pattern should warrant extra or less attention by the sales staff.  Providers of finance such as banks and debenture-holders need information on the company's ability to pay interest and to repay any loans at their due date. As well as the liquidity position, providers of finance may also require evidence of fixed assets as security.  Customers need reassurance that the company is a secure source of supply and in no danger of closing down. The company balance sheet will aid them in obtaining this information.  The Inland Revenue will need information about the profits of the business to enable any corporation tax or income tax due to be assessed. Customs and Excise will also require information on VAT paid and received.  Financial analysts and advisers require information for potential or existing investors. Similarly, credit agencies need information to be able to advise potential suppliers on the reliability of the business. Journalists also fall into this group in supplying information to the public via their publications.

 Investors will want to use current figures, combined with the results from past years, to project what the future earnings will be. They will then decide whether to invest further, to stay with an investment or to sell out.  Finally, information is required by other companies to assess the strength of competition or even to value a company for takeover on the grounds of estimated future prospects.

Financial and Management Accounting Although it is possible to use much of the same accounting information in all parts of the business, the accounting function, and the systems which it provides, falls into two main divisions:  Financial accounting – this is generally concerned with providing the information necessary for decisions to be made external to the enterprise, e.g. by owners, bankers, tax authorities and suppliers.  Management accounting – this covers the supply of information that is internal to the business and is used by the managers to check progress towards a given objective. (a) Financial accounting The financial accounts are meant to give a view of the business's overall financial situation and are intended for the whole range of stakeholders, but most importantly, the shareholders. As financial accounting is involved with the external appraisal of the business, it does not need to go into such fine detail as is often needed for internal management information. This is not to say that it should be any less accurate; merely that a broader outlook is taken. Additionally, certain requirements are specified in legislation for financial accounts, such as the Companies Act 2006. There are essentially three functions encompassed under the general heading of financial accounting.  Book-keeping – This is the recording of all the day-to-day transactions of the business.  Accounting – This is the preparation of statements from the book-keeping records to summarise the performance of the business, usually over the period of one year. The statement showing the progress through the year is known as the profit and loss account; other names for this account are the revenue statement or income statement, depending on the type of organisation or its location in the world. An assessment of the current financial position is also needed, and this will be shown through the balance sheet or financial statement. The amount of detail and information which will be put into the accounts will depend on the needs of the user, but the clarity will depend on the skill of the accountant.  Interpretation – The accounts still need to be interpreted, even if only by comparison with the results of the previous period, for a set of figures produced in isolation as final accounts is meaningless. Is the profit showing an improvement? Did the results come up to expectation? Is the profit showing an improvement? Did the results come up to expectation? There must be comparison to find out, and this forms a part of the interpretation process.

(b) Management accounting Management accounting is the preparation and presentation of accounting information in such a way as to assist management in formulating policies and in planning and controlling the business. Management accounting seeks to provide information which will be used for decision-making purposes. It is essentially concerned with the costs of business. Costing is a far more detailed analysis of the business than financial accounting and involves isolating the separate elements in the cost of manufacturing, trading or providing a service, in order to show the cost of producing one item, one batch of a given number or some other convenient and appropriate unit. The major role of management accounting is not in the past but in the future through the preparation of:  Budgets – These are the financial plans for the next period.  Forecasts – These are plans for further ahead.  Future strategy – The strategy of the enterprise can be planned and the validity of various alternative projects found and appraised through information derived from the system.

F. FINANCIAL ACCOUNTS

In this final section, we shall consider the structure, role and relationship between the two main statements contained in the financial accounts – the profit and loss statement and balance sheet. We shall use an extended example to examine the issues involved. This will be through the accounts of a private limited company – a joinery firm which manufactures a range of products such as bookcases and hi-fi stands for sale to retailers. The business was set up in 1998 and the accounts below are for the most recent twelve-month period. All businesses must produce accounts once a year, although some larger companies also produce interim figures more frequently. This particular business uses an accounting year which runs from 1 July in one year to 30 June in the next.

The Profit and Loss Statement The profit and loss statement for Petal Joinery is set out below. Petal Joinery Ltd Profit and Loss Account for Year Ended 30 June 200X

£ £ Sales 564,901 Opening stock 74,220 Purchases 255,632 less Closing stock 76,175 Cost Of Sales 253,677 Direct labour 120,000 Total Direct Cost 373,677 Gross Profit 191,224 Indirect Costs (overheads) Salaries 80,000 Distribution 17,261 Administration 16,647 Other indirect costs 4,008 Depreciation 15,000 Total Indirect Costs 132,916 Net Profit (before Interest and Tax) 58,308 Interest 3,800 Net profit (after interest but before tax) 54,508 Tax 11,446 Net Profit after Interest and Tax 43,062

Proposed dividend 12,000 Retained profit 31,062

The first thing to notice is that this account covers the whole year and shows a summary of all the flows of sales and costs over that time. The account itself is not difficult to follow. It is in sections – starting with sales and then showing the costs to be deducted, firstly direct costs then indirect costs. What is left of the sales revenue after these deductions is net profit from which interest payments and tax are deducted to find what is left for the company's shareholders. We can now look at the main sections in turn.  Sales These refer to invoiced sales. The business has actually sold the goods and has invoiced the buyer, but has not necessarily been paid yet  Direct costs These are costs which, as the name implies, are specifically linked to the making of the product. There are usually two main direct costs – materials and labour.

(a) Starting with materials, we can see that there was an opening stock of £74,220. This was the stock which was left over at the end of the previous accounting year and is, therefore, the stock the business started with this year. During the year, the business will buy in new stock (called purchases) – for Petal, this comprises wood, fasteners and packaging materials and amounts to £255,632. At the end of the year, i.e. on 30 June, there will be some stock left over for the start of next year (£76,175). To find out how much stock was actually used this year to produce goods which were sold to bring in the sales revenue of £564,901, we can do a simple calculation: Opening stock plus Purchases less Closing stock This gives us the figure of £ 253,677 which is called cost of sales. It represents the value of materials used up in the year to get the sales. (b) The other direct cost is labour. This will be the cost of hiring workers who are directly concerned with making the product – essentially, shop floor workers. In this example, the cost of employing them was £120,000. If we add the cost of sales to the direct labour costs (£253,677 plus £120,000), we get total direct cost. If this is deducted from sales revenues, we get £191,224 which is referred to as gross profit. We can define gross profit as sales revenue less direct costs.  Indirect costs Indirect costs, also known as overheads, are general business expenses. They apply to virtually any business, whereas the direct costs apply only to this particular business. The list of overheads varies from firm to firm, but there are some common features such as salaries and distribution costs (the costs of getting the product to the customers). There could well be others including rent, energy costs, telecommunications bills and so on. One item is of considerable importance and that is depreciation. Unlike most of the other costs, depreciation does not involve any payment by the business. Depreciation is the cost to the business of the wearing out or other reduction in the life of an asset over time. An asset which may be subject to a depreciation charge is any capital asset, such as a machine tool, a computer or a vehicle. For example, a new car might be bought for £12,000, but in four years its value (what it could be sold for) might have fallen to £5,000. Over three years, therefore, it has depreciated by £7,000, an average of £1,750 per year. If the car was owned by a business for business use, the cost of buying it (£12,000) would be spread over the expected life of the asset. In this case, then, the company might depreciate the car at £1,750 per year. This depreciation is treated as a cost. It represents how much of the value of the asset has been used up in the year. Businesses depreciate all fixed assets and charge the depreciation to that year's profit and loss account as an indirect cost. In the case of Petal Joinery, there is a depreciation charge of £15,000 on its fixed assets. The total indirect costs are deducted from the gross profit to arrive at net profit before interest and tax. The figure here is £58,308.

Interest in this case is £3,800 which leaves £54,508 as the profit on which the business pays tax (in the UK, this is corporation tax). Tax has been deducted here at a notional rate of 21% leaving a net profit after interest and tax of £43,062. This profit belongs to the company's shareholders. However, they will not receive all of it as dividend. Some will retained in the business. It will be the Board of Directors who will make this decision. In this instance, the decision has been made to pay £12,000 in dividend and retain the rest (£31,062) for investment in the company.

The Balance Sheet A balance sheet is a statement of the assets and liabilities of the business at a given moment in time. Petal Joinery's balance sheet at the end of their accounting year is as follows. Balance Sheet for Petal Joinery Ltd as at 30 June 200X

£ £ £ Fixed Assets 45,000 (original value less accumulated depreciation) Current Assets Stock 76,175 Debtor 88,537 Cash 18,608 Total Current Assets 183,320 Current Liabilities Trade creditors 80,842 Tax 11,446 Proposed dividend 12,000 Total Current Liabilities 104,288 Net Current Assets 79,032 Total Net Assets 124,032

Financed by Loan 12,000 Issued share capital 60,000 Profit and loss account 52,032 Total Capital Employed 124,032

The first thing to note is that the balance differs from the profit and loss statement in that the P&L account covers the whole year, whereas the balance sheet is for one day only. It is, in effect, a snapshot of the firm's assets and liabilities on this day (30 June). Tomorrow's balance sheet will be different. Initially, we need to be clear about what is meant by assets and liabilities:  An asset is some thing of value owned by the business. It could be cash or machinery or a claim on another business.

 A liability is something which the business owes. This could be debts to suppliers or the bank, or tax payments due to the Inland Revenue. These are all people or organisations outside the business and include the firm's own shareholders. If you recall the earlier discussion on incorporated businesses, companies have a legal identity that is separate from the owners, and any funds invested in the business by the shareholders are treated as a liability. Balance sheets are so called because they always show the balance between assets and liabilities, as well as the equality of the way in which they are financed. Now we can go through the balance sheet section by section.  Fixed assets These assets include plant and machinery. The value shown in the balance sheet will be the original value when new, less the accumulated depreciation since then. In this case, the fixed assets are valued at £45,000 and this represents, essentially, what they could be sold for. This figure will fall again in next year's balance sheet unless some new assets are purchased. The next part deals with current assets and current liabilities. The word current means within twelve months. Thus, a current asset is one which will be converted into cash within twelve months and, similarly, a current liability is a liability which must be paid within the year.  Current assets The current assets in this case are the normal ones to be found. (a) Stock is the value of stock held at date of the balance sheet. It is the closing stock figure from the profit and loss account. (b) Debtors represent all the money owed to the company by customers who have bought goods, but who have not yet paid for them. The balance sheet shows that Petal is owed over £88,537 by its customers on 30 June. This is a current asset because all of it should be paid within twelve months. (c) Cash represents all the cash and cheque account balances held by the business at the date of the balance sheet. If the current assets are added up, they come to £183,320. The business should be able to convert all these assets into cash within the year. (Note that £18,608 is already cash.)  Current liabilities Any business will have a number of current liabilities. For Petal, these consist of £80,842 owing to trade creditors, plus £11,446 of tax owed to the government (for Corporation Tax) and a further £12,000 to be paid out as dividends to the shareholders. All of this will have to be paid out within the next twelve months. It totals £104,288.  Net current assets Net current assets are the surplus of current assets over current liabilities. If we compare current assets and current liabilities we can see that Current assets £183,320 Current liabilities £104,288

Surplus £79,032

This surplus shows that the business should have enough cash coming in the next year to be able to pay all of its liabilities and leave something over. It could be said that it seems to have a strong liquidity position.

 Total net assets If we add together the company's net current assets to its fixed assets, we get the value of the total net assets belonging to the business.  Financed by If a business is holding net assets, they must be being financed in some way. The final section of the balance sheet shows where this funding comes from. Here we can see that £12,000 is financed by a loan, and the balance comes from the amount shareholders contributed by buying shares (the issued share capital) plus the accumulated retained profits which the business has made over the years (including that shown in the current profit and loss account). We can say that the shareholders have a total equity in the business of their shareholding plus the retained profits figure. Bear in mind that all profits belong to the shareholders, whether or not they have actually been paid to them as dividends. In this case the shareholders have an equity stake of £60,000 plus £52,032 – a total of £112,032.

Connections Between the Accounts Although the profit and loss account and the balance sheet are different in that the former is a statement of flows over time and the latter is a statement of the values of assets and liabilities at a given moment in time, the two are connected. Certain items from the profit and loss account also show up in the balance sheet:  The closing stock figure in the profit and loss account becomes the current asset stock figure.  The dividend which has been decided on, but not actually paid, appears as a current liability. It is money owed to shareholders.  The same thing occurs with tax which appears as a current liability, indicating that the tax will have to be paid within the next year.  Less obvious is the treatment of the retained profit figure in the profit and loss account. This will have been included in the profit and loss account item in the "financed by" section of the balance sheet. If we had seen the previous year's balance sheet, that figure would only have been £20,970, with the retained profit from this year bringing it up to its present figure of £52,032. Any day-to-day transaction will affect the balance sheet. For example, suppose a debtor sends in a cheque for £5,000. In the balance sheet, the debtors figure will fall by £5,000, but the cash figure will rise by £5,000. The balance sheet has changed, but it still balances.

Stakeholder Perspectives We can now take a more detailed look at the way in which the various stakeholder interests, which we reviewed earlier, may be satisfied from the final accounts. In each case, we shall see that the accounts need to be interpreted to provide the information that they need.  Shareholders The interests of shareholders are profits, the size of the dividend and the share price. The business is making a net profit of £58,308 before interest and tax. If interest is deducted, we are left with a pre-tax profit of £54,508 which can be said to be attributable to the shareholders. The question is: is this satisfactory or not?

One way of looking at the situation is to calculate the Return on Capital Employed (ROCE). This is the profit as a percentage of the total capital invested in the business by both shareholders and creditors. The total capital employed is £124,032 (see "financed by" in the balance sheet). Thus, pre-tax profit as a proportion of total capital employed is: £54,508 100  43.94% £124,032 If we take the profit after tax (£43,062), the figure is 34.72%. This shows that, for every £1 invested, the business is making 43.94 pence profit (pre-tax) or 34.72 pence (after tax). Shareholders can compare this return with other possible investments to see if this is satisfactory. The dividend payable amounts to £12,000. If it is assumed that the issued share capital of £60,000 is made up of 60,000 individual shares with a nominal value of £1, then it can be said that the business is paying 20 pence per share in dividend. As this is a limited company, there is no marketplace for the shares so the share price cannot be calculated. Overall, it might be thought that shareholders are doing well. Dividends are high as a return on the nominal value of the shares and there will not be many investments doing better that the 48.5% return on capital earned here. Having said that, it needs to be borne in mind that this is a business and carries a degree of risk – a good performance this year does not mean that the same will happen in the future.  Directors and managers There is no information in the accounts to indicate what the objectives and targets of the business were for the year, and directors and managers are specifically concerned with comparing outcomes with targets. However, there is still plenty of information for the management of the organisation in these statements. The profit figure seems satisfactory, but there are other ways of looking at this figure which provide more pertinent information to the directors and management. In particular, the ratio of profit to sales is important: (a) Gross profit margin is the ratio of gross profit to sales. Gross profit is £191,224 and the business is making sales of £564,901. Gross profit therefore represents 33.8% of sales which means that for every £1 of sales the business is making 33.8 pence gross profit. (b) Net profit margin is the ratio of net profit to sales. Net profit is £58,308, which represents 10.3% of sales and so the business is making 10.3 pence profit on every £1 of sales. The difference between the two figures is the company's overheads. The directors and management might possibly want to ask why there is such a gap between the gross and net margins. If overheads could be cut then the net margin would increase. Whether this is a problem in this case would depend on a range of factors, and it would be useful to compare the figures with similar businesses elsewhere.  Workforce The wages of the shopfloor direct labour force amount to £120,000. Total direct and indirect costs come to £506,593, so wages represent just over 23.5% of total costs. Even if the wage bill was to rise by 10% to £132,000, wage costs as a proportion of the total would only rise to 25.5%. The workforce and their trade unions might feel that a pay rise could easily be afforded. Given the apparent strong financial position of the business, this could be conceded without much risk of job losses.

As far a salaried staff is concerned, they might take a similar position. However, their salaries are part of overheads, and as we have seen, directors and management might be looking to trim overheads.  Suppliers (trade creditors) Suppliers are predominately concerned with being paid and with ensuring continued orders. As far as being paid is concerned, the business seems to be in a strong liquidity position. It has £18,608 in cash against trade debts of £80,842 but should receive over £88,000 from debtors in the next twelve months. Furthermore there is current surplus of current assets over current liabilities of £79,032. Suppliers and creditors should feel secure.  Banks and other finance providers Institutions that lend money to businesses want to keep a regular check on the "risk" associated with the loan and the ability of the firm to repay the debt and interest. They can do this by analysing the short- and long-term "liquidity" of the business using ratios. Short-term solvency can be assessed using: (a) Current ratio This measures how well a company's short-term assets cover its liabilities. The ratio must be at least 1, but preferably between 1.5 and 2. Current assets Current ratio = Current liabilities

£183,320 Current ratio = = 1.76 £104,288 (b) Acid test ratio A better test of liquidity is the acid test ratio. This only uses current assets that are easily converted into liquid funds such as cash and debtors. It ignores stock which may prove difficult to convert to cash without offering a significant discount, thus damaging profit margins. In general, the ratio must be at least 1, indicating that the business can easily settle its short-term debts. Current assets - Stock Acid test ratio = Current liabilities

£183,320 - £76,175 Acid test ratio = = 1.03 £104,288 Long-term solvency can be assessed using gearing ratio. Long-term solvency measures the ability to pay all of a firm's debts. Gearing measures the capital structure of a business, i.e. the relationship between long-term liabilities and total capital employed. High capital gearing would leave a firm prone to dangerously high interest repayments. Long term liabilities Gearing ratio = x 100% Total capital employed

£12,000 Gearing ratio = x 100% = 9.67% £124,032

The business is financially sound as both of the short-term ratios meet the criteria and the business is low geared.  Competitors All that can be said here is that competitors are likely to compare their own performance with that of Petal Joinery. One method of doing so is benchmarking – selecting certain performance indicators from other businesses against which to judge your own performance. The gross and net profit margins are easy to work out and would be one such indicator.  The State The main interest of the State in the final accounts, apart from a general interest in the future well-being of the company, will be the position as regards tax liability. In particular, there will a concern to ensure that the taxable profits of the company (net profit after interest) are correctly reported and that the level of costs seems appropriate to sales. One way in which this may be checked is to compare the accounts with those of the previous year.

Study Unit 9 The Human Resources Function

Contents Page

Introduction 173

A. Concept and Scope of Human Resource Management 174 From Personnel Management to HRM 174 HRM and Stakeholders 175 The Corporate Role of HRM 176 The Importance of HRM 176

B. Human Resource Planning 176 The Planning Process 177 HRP Strategies 179

C. Recruitment and Selection 182 The Vacancy 182 Recruitment Sources 183 The Application Process 186 The Selection Process 186 Employee Induction 188

D. Training and Development 189 The Organisational Context 189 What Is Training and Development? 190 Training Methods 192 Competency-Based Training 193 Professional Education 193

E. Motivation 194 Theories of Motivation 194 Motivational Factors at Work 197 Job Satisfaction 198

(Continued over)

F. Remuneration 199 Influences on Payment Policy 199 The Total Remuneration Package 201 Payment Structures 201 Performance-Related Pay 202

INTRODUCTION

Human resource management (HRM) is the management of the various activities designed to enhance the effectiveness of an organisation's workforce in achieving the organisation's goals. An organisation's workforce is its most valuable asset and, in many cases the most expensive – particularly so in service organisations where there is less application of machinery. It is vital, then, to both the performance of the organisation and the value for money obtained from employing staff, that the organisation gets the best staff available, deploys them suitably in appropriate jobs, ensures they have (and continue to have) the knowledge and skills required, provides a working environment – including appropriate pay and conditions of employment – which will encourage them to continue to work for the organisation, and deals quickly and efficiently with any problems which occur in the relationship between employers and employees. In tackling these issues, the subject of HRM is generally divided into three distinct branches:  employee resourcing, which is concerned with obtaining and retaining staff and their deployment in jobs through the activities of planning, recruitment and selection, pay and other rewards, and ensuring general working conditions which motivate and satisfy staff;  employee development, which is concerned with ensuring that employees' skills remain relevant to the changing demands of work and that motivation is maintained;  employee relations, which is concerned with reconciling conflict between the rights and interests of employers and employees through the adoption of appropriate strategies and procedures. The key elements with which we shall be concerned in this unit are those covered by employee resourcing and employee development. Note that, whilst there is invariably a separate department in most organisations dealing with HRM, the management of human resources is not something which is the property of such a department. Rather, the principles and practices of HRM are an integral part of management across the whole organisation. Objectives When you have completed this study unit you will be able to:  Distinguish between personnel management and HRM, and describe the range of activities encompassed by HRM and its importance to the business and to the stakeholders of the business.  Describe the objectives of human resources planning and explain the processes involved.  Explain the processes whereby new staff are recruited into an organisation and identify the objectives of each stage.  Explain the role of training and development in assisting an organisation to meet its objectives and describe the ways in which training and development can be carried out.  Outline the main approaches to understanding motivation and identify the factors which may be said to motivate staff at work.  Discuss the assertion that pay is a great motivator with reference to principal theorists.  Describe the range of payment systems.  Define and calculate labour turnover.

A. CONCEPT AND SCOPE OF HUMAN RESOURCE MANAGEMENT

Every organisation, whether large or small, has employees who work hard to secure and maintain its position in the marketplace. Each employee has his/her own wants and needs: the need to be paid for work completed; the need to be looked after while at work; the need to be motivated, etc. Traditionally these needs and wants have been met by a "personnel" department, but there has been a gradual change. The late 1980s and early 1990s saw the advent of the concept of HRM. This has similarities with traditional personnel management, insofar as it is concerned with employees' needs at work – but it has a much harder, business-like facet to it. HRM recognises employees as resources who should be treated like any other resource within the company. This includes having the capacity to respond to the mission, goals, objectives and strategy of the company, to cope with peaks and troughs in demand and production, and to adapt quickly and effectively to change.

From Personnel Management to HRM The re-orientation of the function may be seen in the following two definitions, both by Torrington and Hall (1998):  Personnel management is "workforce-centred, directed mainly at an organisation's employees, finding and training them, arranging for them to be paid ... satisfying employees' work-related needs, dealing with their problems and seeking to modify management action that could produce an unwelcome employee response."  HRM is "resource-centred, directed mainly at management needs for human resources (not necessarily employees) to be provided and deployed. Demand rather than supply is the focus of the activity. There is greater emphasis on planning, monitoring and control rather than mediation." Traditionally, personnel management was seen as having an essentially "nurturing" role, which included, as the above definition suggests, looking after the needs of the employee. It was also seen as a "mediator" between management and employees, bridging the gap between both parties. Because of this some managers tended not to view personnel as a legitimate management function and, as a consequence, did not give it the respect it deserved. HRM is more concerned with the corporate needs of the company, as opposed to employees' needs. It is seen as the strategic arm of the overall personnel management function and is very much geared to viewing employees as resources to be deployed and utilised just like any other resource. HRM is resource-centred and ensures that each department within the company is provided with human resources that have the right skills, qualifications and experience. However, these human resources do not necessarily have to be core employees (directly employed by the company), but may be peripheral workers (contract and agency staff, part-time staff, etc.). The importance of HRM as a corporate function which is central to the success and longevity of the company is shown by the organisation chart of senior management in a typical company in Figure 9.1. Here, the function is an equal member of the management team. Indeed, it will invariably be represented at board level. As with other corporate functions, HRM has its own role to play in overall strategy formulation. It also works to ensure that all the corporate functions are resourced with skilled, qualified and experienced human resources.

Chief Executive

Manufacturing HRM Sales Research & Development

Marketing Finance Administration

Figure 9.1: HRM in the Corporate Structure

HRM and Stakeholders HRM exists within an organisation to serve the interests of both internal and external stakeholders. Increasingly, these stakeholders are being viewed as customers and they all have their own expectations of the "service" they expect HRM to provide.  Senior management At the corporate level, management will expect the HRM function to contribute to the achievement of corporate strategy by deploying the appropriate resources to facilitate the implementation of its strategic choices, devising and implementing policies and procedures, and leading the implementation of change.  Line management At the operational level, managers expect HRM to provide them with accurate advice, guidance and "service", such as resourcing their departments with appropriately qualified and experienced employees.  Employees and trade unions The workforce in general expect the HRM function to facilitate the provision of good working conditions and terms and conditions of employment, including equality of treatment and opportunity and rewarding jobs. The trade unions, as representatives of the workforce, will expect HRM to encourage management to adopt employee participation (involving employees in decision-making and problem-solving by means of quality circles and joint consultative committees). We could also include here the interests of potential employees who may expect HRM to provide them with appropriate information about the job for which they are applying (within a reasonable time limit) and to practise good and fair recruitment and selection procedures.  Suppliers and customers External organisations and individuals doing business with the organisation will expect HRM to provide customer service training for front line staff; to recruit "good" employees in order to produce high quality products and provide good quality of service; and to maintain employee harmony that ensures a strike-free environment.  Government bodies/agencies The State will expect HRM to help the organisation comply with legislation and meet its legal and moral obligations (such as liaison with the Inland Revenue, Employment Service, registration for VAT, compliance with health and safety legislation, etc.).

The Corporate Role of HRM All these stakeholders expect a high level of service, and considering the range of expectations that the HRM function must meet provides an extended statement of the role of HRM. As can be seen, it overarches every corporate function in the company. In particular, human resource specialists carry out the following roles:  Planning – formulating human resource plans to facilitate the acquisition, utilisation, development and retention of human resources and contributing to corporate strategy formulation at board level.  Corporate management– participating in negotiations with trade unions, formulating procedural agreements (policies for negotiation rights, procedures for discipline and grievance handling, etc.) and substantive agreements (policies for terms and conditions of employment, sickness pay, etc.).  Advisory service – advising line managers on the implementation of HRM policies and procedures.  Service provider – providing recruitment services to line managers, arranging training and development, counselling employees and dealing with problem people, etc.

The Importance of HRM HRM is important because its actions directly affect the labour force. Satisfied workers will be loyal and are less likely to seek employment elsewhere. Dissatisfied workers will actively seek new employment, leading to a higher labour turnover. An increase in labour turnover indicates that employees are dissatisfied with management, dissatisfied with working conditions or are unhappy about the rate of pay. Whatever the reason, a firm should be concerned because replacing employees on a regular basis is costly in terms of time and money. Every replacement results in recruitment costs such as advertising, interviewing and induction training. Departing employees represent lost skill and lost investment in training and expertise. These can only be replaced once the new recruits have gained sufficient experience. Labour turnover is the rate at which employees leave a business. In its simplest form, labour turnover can be calculated using the equation: Number of employees leaving x 100% Total workforce To keep labour costs down, the turnover in staff must be minimised. This can be achieved with effective human resource planning (HRP).

B. HUMAN RESOURCE PLANNING

HRP is the process which sets out to ensure that an organisation has the right quantity and quality of employees doing the right things in the right place at the right time and at the right cost to the organisation. HRP has been defined as a technique to facilitate the acquisition, utilisation, development and retention of a company's human resources. These resources are considered by some to be the organisation's most valuable asset and, therefore, need to be utilised in the right way, for the right remuneration, in the right job, at the right time. The "hard" side of HRM dictates that human resources should be treated like any other resource in the company. As such, mechanisms need to be in place to ensure that the appropriate supply of staff is available when required.

Failing to establish a correct balance between the supply of, and demand for, labour in an organisation can lead to either:  shortage of staff – if a business employs fewer staff than it requires, it is unlikely to be able to meet its production and sales targets, machinery and stock will be unused, and its trading profit is likely to be reduced; or  surplus of staff – a business which finds itself employing more staff than it needs will incur wage and salary costs which cannot be funded by using such staff in productive forms of activity. These and other problems occur regularly in business, as employers have to adjust their trading plans in accordance with continual changes in marketplace conditions. HRP cannot protect an organisation from the need to adjust its personnel policies in response to changes in the marketplace. It can, however, provide for a more orderly adjustment, by attempting to identify in advance the trends in demand and supply of staff which indicate whether future needs should be met by recruitment and training of new staff – or, alternatively, by reducing the size of the workforce. The importance of HRP is that it provides the means of ensuring that personnel policies and their objectives are properly integrated into the business policies, goals and objectives.

The Planning Process The process of HR planning is complex, but in its simplest form it centres around three main activities: (a) forecasting the demand for staff within the various corporate functions. It entails analysing the information and determining the number and types of staff that will be needed at any given time. (b) identifying the supply of labour available in terms of the demand for particular numbers of staff with specified skills and other attributes (for example, location). (c) bringing together the demand and supply in a planned, proactive manner to ensure that corporate functions are staffed with the right people at the right time, basically on demand from department/line managers, in order to meet the peaks and troughs in the company's day-to-day operations. The process can be seen as comprising four stages, as discussed below. Each of these is carried out on an ongoing basis. HRP can never be the kind of exercise which is carried out, put into effect, and left for five years. In order to be of value it must be maintained and adjusted to take account of new trends as they emerge. The forecasts which are made at any given time can never be a precise prediction of what will happen to either the demand or supply of labour. Policies based on such forecasts cannot therefore be maintained indefinitely; they must be adjusted as new information becomes available.  Analysis of existing resources This will create a profile of the workforce, based on certain characteristics which are relevant for planning purposes. An accurate picture of the composition of the workforce and analyses of important features of its deployment, such as absence and overtime, are essential in HR planning. The information which is required falls into the following main categories: (a) Inventories of existing workforce – a statistical analysis of the number of employees, divided into different categories. (b) Staff turnover – an analysis of the rates at which staff are leaving employment and of trends in the characteristics of staff turnover.

(c) Costs – personnel policies should, where possible, be based on information which identifies the cost implications of alternative courses of action. It is, for instance, useful to know at which point recruitment becomes more cost-effective than increased overtime working. (d) Use of staff – in many cases a raw headcount of numbers employed is inadequate as a basis for planning future personnel policies as this must take account of the objective of improving efficiency in the use of staff. For this purpose, information relating to the way in which staff work is needed, including overtime working, absenteeism, ineffective or wasted time and efficiency in the use of labour.  HR demand forecasting The HR demand forecast is an estimate of the numbers of staff required in order to carry out the level of business or service which is anticipated. The basis of this forecast should be an analysis of the staffing requirements necessary for the organisation to succeed in achieving its business objectives, taking into account the requirements of the corporate plan. This will be done using the workforce profile and adjusting it to define overall numbers, skills and attributes of the human resources needed in the future.  HR supply forecasting The supply of labour will depend on the availability of suitable staff who can be recruited from outside the organisation and the potential for developing existing employees to meet new requirements. This means assessing the internal and external labour market. The composition of the existing internal labour market is given by the workforce profile. From the point of view of the future supply of labour, that profile needs to identify: (a) The age breakdown of employees and the relevant concentration in each of the departments. The company will also need to determine whether there are any imbalances in age (such as a large number of older workers against young workers and school leavers). (b) The gender breakdown of employees and the relevant concentration in each department. This will identify any gender imbalance (more men in relation to women). The same applies to ethnic groups. (c) The breakdown of skills, giving an indication of the existing skills within the organisation and highlighting any areas of skills shortage (training and development or external recruitment may be necessary to meet these shortages). (d) Succession planning, which will determine the type and calibre of managers available to succeed senior or middle managers who retire or leave. If the company does not have the internal human resources that it needs to continue its operations, it must look to the external labour market. The external labour market is basically a "pool" of potential employees into which an organisation can tap. The external labour market can be local, national or international and take into account factors such as: (a) The breakdown of the population in an area – covering issues such as class, age and gender, social mobility, etc. (b) The breakdown of skills, qualifications, etc. (c) The number of school leavers available and eligible to apply for jobs.

(d) How other companies compete for available labour and the type of package (pay, benefits and incentives) they are prepared to offer individuals in order to attract them. (e) Unemployment in a particular area (areas of high unemployment may not be a good thing – the available labour may not have the skills employers want).  HR plan By bringing together information obtained from the first three stages, an analysis of the action required to bridge the gap between the demand forecast and the supply forecast is made. The options for this are considered in the next section.

HRP Strategies Once the company has analysed its position in terms of the current level of staff and the likely number it will need to secure the continuation of its operations, it will determine whether it has a surplus or deficiency of staff. If demand for the company's goods/products or services falls and leads to a drop in output, a surplus of staff may be identified. Companies can make contingencies for both a shortage and a surplus of staff.  A shortage of staff There are a number of options for dealing with this situation: (a) Promote, transfer or second internally (b) Recruit externally (c) Redeploy or retrain staff (d) Increase the number of part-time staff (e) Use agency staff (f) Extend temporary or fixed-term contracts (g) Offer employees the opportunity to work overtime (h) Re-design jobs – for example, if you normally have five staff in a category where there is a scarcity of skilled employees, it may be possible to remove routine, undemanding tasks from the jobs and reduce the complement of skilled staff to four; you can then create one new job for an assistant with a less demanding specification which will not present recruitment difficulties. These strategies will be reflected in a number of plans and policies: (i) Recruitment plans for each part of the organisation for planning the hiring of staff from internal and external sources, specifying numbers required in each category, and provision of the necessary resources. (ii) Training and development plans specifying numbers of staff in various categories who will require training, what kinds of courses are required, and resources needed. (iii) Developing a policy of exit interviews with a view to finding out why employees leave the company; this may, in the long term, lead to a reduction in labour turnover.  A surplus of staff The options where this situation applies are as follows.

(a) Stopping recruitment – putting a freeze on any further recruitment externally, either in specified types of staff or across the board. (b) Using natural wastage – as workers leave they are not replaced. (c) Seeking redeployment/transfers – employers have a statutory obligation to seek alternative employment for employees whose jobs are threatened by redundancy. Restrictions on the mobility of staff, both geographically and occupationally, inhibit the scope for redeploying staff, but the prospects should be investigated. (d) Encouraging early retirements – staff inventories can indicate the numbers of staff members due to retire at normal dates and the potential number who might consider retiring earlier. This can be an expensive way of reducing staff numbers, if compensation for reduced pension entitlement is provided. (e) Reducing overtime – a substantial amount of overtime may be worked on a regular basis. It makes good sense to reduce, or even eliminate, this work, if there are risks that some employees will be made redundant. Trade unions may react to a threat of redundancies by banning overtime work anyway. (f) Implementing short-time working – this option is often used in manufacturing companies. It involves putting the workforce on a reduced working week for a limited period, in the hope that business will improve and redundancies can be avoided. It is unlikely that short-time working can be sustained for longer than a few months but, in some instances, this may be all that is required to survive a lean period. Declaring redundancies and then needing to recruit staff in a few months' time is embarrassing and costly. (g) Reducing subcontracted work – some companies do not rely entirely on their own workforces but subcontract a proportion of work which they are capable of undertaking. When the jobs of their own employees are threatened, they can reduce the amount of subcontracted work. (h) Redundancy: involving permanently reducing staffing levels (known as downsizing) and laying off members of the existing workforce. The process may be voluntary or compulsory. Whilst this course of action is often a last resort and is certainly drastic for the staff concerned, companies may be able to take the opportunity to restructure the remaining staff and make operations more efficient and productive. In order to cope with peaks and troughs in demand many organisations are now adopting flexible working methods. Such methods enable organisations to make more efficient use of their human resources, and give employees a certain degree of flexibility in their jobs. The organisation of job flexibility is the responsibility of the HR department, in negotiation with the union (to ensure good employee relations are maintained). It is a major change that may have far-reaching implications for the organisation, not just its employees. The main methods of flexible working include the following. (a) Overtime This allows companies to cover peaks in production by offering premium payments (such as time and a half or double time) to employees, for work over and above their normal working hours. However, overtime working can be open to abuse, with some employees working more slowly during the day to ensure that there is the need to work overtime. (b) Flexi-time Flexi-time gives employees the opportunity to determine when they come in to work and when they go home (within certain parameters). "Core time" is the time when employees are required to be at work (usually between 10.00 am and 4.00 pm). For

example, if their normal working week is 37 hours, individuals can determine the hours they work during each working day, around the core time, as long as the hours at the end of the week add up to 37. Companies usually have a recording mechanism to ensure that employees do not abuse the flexi-system. Developments from flexi-time systems include monthly or annualised hours systems, where workers are required to work particular numbers of hours or days over the period, but exactly when may be determined by either the staff themselves or the employer. (c) Shift working Shift working allows the production process to be ongoing so that the factory environment never really shuts down (apart from during holiday periods). It effectively optimises the utilisation of employees and machinery. Different types of shift working systems include: (i) The Continental System Organisations are increasingly moving over to a continental pattern of shift- working. It involves employees working a rota such as two mornings followed by two nights followed by two or three rest days. In some companies it means 12- hour shifts on each occasion worked, but it means that employees have "rest days" to catch up on lost sleep, etc. It is a popular option with some companies as it gives employees variety, and also means that staff have more time to spend with their families and on leisure activities. (ii) Three Shift System Here employees work a pattern of three shifts: mornings (7 am to 2 pm), afternoons (2 pm to 10 pm) and nights (10 pm to 7 am). When employees work the night shift they usually work four nights (Monday to Thursday inclusive) and go home on Friday morning. Friday nights are left free. As you can imagine the night shift (as well as shift working per se) puts enormous psychological and physical stress on individuals. (d) Teleworking Teleworking involves working from home, with employees being linked to their employers by computer, telephone and sometimes fax. The benefits of teleworking include: (i) Allowing single parents to work from home, thus fitting their work around looking after their children. (ii) Enabling disabled people to work from home, thus reducing the discrimination they may face in the workplace. (iii) Savings in accommodation costs for the employer. (iv) A possible reduction in stress, as teleworkers do not have to commute to work and therefore do not run the risk of getting stuck in traffic jams etc. (e) Home working Home working affords individuals the same benefits as teleworking and may include freelance or self-employed workers such as market researchers, graphic artists and editors. Homeworkers can also include mobile hairdressers, financial consultants, etc. (f) Job share Jobshare allows individuals to, quite literally, share jobs. This is ideal for people who want responsibility but only want to work half the hours. Tasks are shared equally

between job-holders, which increases personal flexibility for workers, but there may be practical difficulties of liaison between the two part-time staff members in some cases. The earnings are also shared. This is, clearly, a limiting factor to many staff who are dependent on income from full-time employment. Job-sharing is most likely to appeal to staff who have domestic commitments and thus prefer part-time work to full-time work, or to older employees who may regard part-time work as a compromise between full-time work and retirement.

C. RECRUITMENT AND SELECTION

People are the most important aspect in any business and management should make every effort to get the right people in the right jobs at the right time. For a company to stay competitive it must recruit and retain an efficient and effective team of employees. The selection of staff may be carried out by many people in an organisation. Large organisations have HR departments to handle part of the process, whilst smaller ones rely on individual managers or supervisors to select their own staff. Whatever the size of the organisation, a manager will have a contribution to make in the area of recruitment. In a large enterprise, the HR department will place advertisements and carry out the preliminary selection procedures, but they will still need input from individual managers in order to produce accurate job descriptions and to make final choices of suitable candidates. In a smaller enterprise a manager may have to complete the whole process him- or herself. Whatever the input required of a manager in choosing staff, it is an important skill and it can be costly for the organisation if the wrong staff are selected.

The Vacancy Recruitment is necessary when either an existing employee leaves or a new position is created. Whatever the reason, organisation analysis should be completed to assess whether there really is a vacancy or whether the work could be done somewhere else. Reorganisation of work or training could solve the problem. Alternatively, we can see if there are any existing staff who could fill the position as it is probably better for organisations to try to recruit internally. This approach has two benefits:  It is cheaper, and  It allows the organisation to train and develop staff into the existing culture. Alternatively, new positions may be part of a strategic manpower plan; if so, this should be checked to make sure it is still current. The context of the job should be clarified. Where does it fit into the existing structure relative to grades, pay and reporting lines? Is it clear what the recruitment procedure will be? Note that many organisations in the UK promise staff that all vacancies will be notified internally first (usually with a proviso saying "where appropriate"). Apart from this organisational context, the job itself must be considered:  Job analysis is the process of collecting and analysing information about the tasks, responsibilities and the context of jobs. The objective of this exercise is to report this information in the form of a written job description. Job analysis and job descriptions are used in both HRP (defining the requirements of the organisation) and training needs analysis (to determine the training gap between the requirements of the job and the skills of the individual). Job analysis information is also used in the recruitment and selection process, since the applicant needs to know details about the job, and the organisation uses the relevant information to define the individual characteristics which are required to do the

job satisfactorily. Job analysis can therefore considerably assist the effectiveness of the process of matching individuals to jobs.  Job descriptions are used in the recruitment process to set the parameters of the job. A good job description covers the total requirements of the job: the who, what, where, when and why. The key elements are as follows: (a) The job title (b) To whom the job-holder reports (possibly including an organisation chart to show where the job fits in) (c) Primary objective or overview – the job's main purpose (d) Key tasks (e) How the responsibilities are to be carried out (f) Extent of responsibility A job description may also include key contacts and basic conditions of work.  The person specification identifies the skills, knowledge and attitudes required to perform the tasks and duties identified in the job description. Careful analysis of the job requirements enables the parameters to be set of the person required so that the essential and desirable requirements can be identified.

Recruitment Sources When authorisation to recruit has been granted, and job and person specifications have been prepared, there is, first of all, a basic choice to be made as to whether applicants for employment should be sought from within the organisation or whether it will be necessary to recruit from any one or more of a number of external sources.  Internal sources The mechanics of contacting internal candidates are quite straightforward – details can be put on a notice board, or published by means of a circular – in any organisation which employs staff in a number of different offices. There are several advantages in recruiting staff internally, as well as several disadvantages. The advantages are: (a) It is cheap. Few direct costs are incurred. (b) The advice of managers who know the applicants can be obtained. Written comments may be available if a performance appraisal system is in operation. (c) Offering promotion to staff is a good policy. It helps to satisfy their ambitions, encourages them to seek promotion and may help to motivate the workforce to greater effort. The disadvantages are: (a) For many jobs, particularly those that are highly specialised, the number of applicants from internal sources is likely to be limited. If recruitment is only internal, the manager may then be required to accept an applicant who is less suitable. (b) Delays sometimes result from the fact that a whole series of replacements have to be recruited, starting from a vacancy at the lowest level. (c) Although there may be a motivational effect from offering promotion to some staff, there may also be a sense of grievance in those who are unsuccessful.

 External sources There are several external recruitment sources which may be used, either on their own or in combination. No single source is better or worse than the others. Managers must evaluate each source in relation to its merits for particular vacancies. (a) Advertising Many jobs are filled in response to advertisements. To be successful, the advertisement should be well-worded and placed in an appropriate medium. The choice of medium depends on the nature of the job, i.e. low-grade clerical jobs in local weekly newspapers, more specialised jobs in regional or national papers and sometimes in trade and professional journals. The cost and delay will be greater for these higher-grade positions. (b) Job Centres These are located in High Street shopping centres and they act as an intermediary, introducing prospective applicants to employers who have notified vacancies to the Job Centre. The service is provided free of charge. Administrative, professional and technical posts are dealt with by a separate wing of the public employment service, known as PER. (c) Agencies Private employment agencies may operate on a nationwide or on a local basis and usually work on a "no placement, no fee" basis. Introductions are made to employers and, if and when applicants are employed on a permanent basis, a fee is charged which is usually a proportion of the starting salary. The service can be quick but is expensive. Most agencies specialise in a particular type of vacancy. Agencies have grown in importance in recent years and have the advantage of reducing costs in the recruitment process and providing specialist recruitment staff. However, the disadvantage is a loss of control over who is shortlisted and selected. (d) Consultants (headhunters) This type of agency is more expensive and is used for more demanding and high- ranking positions. The service provided usually includes advertising and preparing a profile. Preliminary interviews are carried out and a small number of applicants, well matched to the profile, are presented to the client. (e) Universities and colleges When the recruitment is for recently qualified graduates, it makes sense to contact the educational establishments directly. Most universities and colleges operate careers services, providing introductions to employers free of charge. (f) Careers offices These are a good source of school-leaver applicants for appropriate vacancies. (g) Casual enquiries These occur where applicants write or call. It is a free source and applicants can be provided quickly. (h) Recommendations These may be made by existing employers and other contacts and are often a cheap and quick source of new staff. There is, however, a potential problem in that the people recommended are likely to be of the same social and ethnic groups as existing staff. Therefore you may

be preventing the same diversity from appearing as you would expect to find in the local environment. An individual who could do the job but who is from a different social/ethnic group could claim that he or she has suffered racial discrimination if recruitment is mainly by way of recommendation.  Which source? The choice of recruitment sources for particular vacancies should take account of factors such as: (a) The speed with which it is necessary to fill the vacancies. Time is a difficult element to manage in the recruitment process. How long does it take to fill a vacancy? This will depend on various factors such as: (i) The method chosen for attracting candidates: If advertising a vacancy, the time which can elapse between booking advertising space in the next edition of a publication and the advert appearing can vary significantly depending on the publication chosen, e.g. daily, weekly, monthly. If internal recruitment or word of mouth is used the replacement can be found almost instantly. (ii) The interview procedure used – for example, a single interview, or a series of different interviews or tests. (iii) The period of notice that the successful candidate is required to work at their previous place of employment. (iv) It is possible that no suitable candidates apply at the first attempt and you have to wait until you can find a suitable person for the job. In some industries there are only certain times of the year when people change jobs, e.g. in education, where term-time is static, and in travel where jobs are seasonal, etc. (b) The costs involved. Cost is an important element in effective recruitment. At one end of the scale, word-of-mouth methods of attracting candidates cost nothing, whilst using headhunters or recruitment consultants costs a percentage of salary (and as this method is only likely to be used for top positions this means a considerable amount of money). Once candidates have been attracted, time must be spent screening, selecting for interview, interviewing and testing them. There is a significant time cost tied up in these procedures. There is also the cost of work which is lost or productivity which falls due to staff being involved in the selection process and not having as much time to spend on their usual tasks. The position which is being filled may be empty for a time during the recruitment process and this may cause loss of production or a drop in activity. (c) Making sure you have selected the right person for the job. Quality should not be compromised without careful consideration. It is not always possible to employ the perfect person for the job but it is definitely a mistake to take on a person who is clearly unsuitable just because the constraints of time or money have put the pressure on. It would be better to leave the position unfilled and use a contingency plan until a suitable candidate turns up. It may also be worth thinking again about the vacancy and the duties involved; it may be better to reallocate duties and move people around internally to create an alternative vacancy which should be easier to fill with a good candidate.

The Application Process Once potential candidates have become aware that a position that interests them is available with a company the process of application begins. The form of application is important as it should enable the candidate to present him/herself in the best possible light in relation to the job description and person specification. It should also enable the recruiting organisation to screen applicants in respect of the same criteria and make an initial selection of possible candidates from all those who apply. This process is called shortlisting and those selected at this stage will go on to the final selection procedure. There are number of types of application – the one chosen will depend on the type of job on offer and the expected number of applicants.  By application form: A standard or specifically designed application form is completed by candidates. The application form is obtained by written or email request, telephone request, collection from the premises, etc.  By curriculum vitae with covering letter: A candidate may be asked to send a CV with a letter outlining what makes him or her interested in, and suitable for, the position.  In person: Some unskilled jobs are filled on a first-come first-served basis, with candidates presenting themselves at the premises and being employed on the spot, subject to basic suitability and eligibility checks.  By telephone: It is common for candidates' initial contact to be by telephone. The candidate gets the opportunity to find out more about the position and the company has an opportunity to make initial selections.  By open forum: This is when all interested candidates are invited to attend a forum where further details of the position will be given. Candidates will then often complete application forms or be involved in other selection procedures at the same meeting. Whichever of these methods is chosen, it is usually only a first step and a basis for separating those candidates with potential from those who would seem to be unsuitable. The first step in screening the applications is to reject applicants who do not meet the minimum requirements. These applicants should be contacted as early as possible and informed that you do not intend to pursue their application. This communication should be professional and polite, as should all dealings with the applicants. Although they may not be suitable on this occasion, they or their friends may be just what you are looking for next time, and, of course, they may be customers or other people with an interest in the organisation, like local residents or even shareholders. How you decide to proceed next will depend on the number of suitable applicants, the timescale involved, and the resources available to spend on the selection process. If there are a few applicants who meet or exceed the minimum requirements, then it would probably be appropriate to pursue all of their applications, but if the organisation is swamped with apparently suitable applications then further sifting out is necessary before any candidates can be given individual personal attention.

The Selection Process The decision on who will be selected for any particular job will rest on a variety of contributory factors. The candidates' experience and qualifications must be assessed in a relatively objective way, based on factual information. The skill in selection comes with making correct decisions in the less factual areas where objectivity can be difficult. Is the person reliable and adaptable? Will they get along with their colleagues? Is their motivation for applying the right motivation? You cannot avoid your personal tastes and opinions contributing to the way you react to individual candidates, but you should try to remain as objective as possible. There are a number of established techniques for selecting candidates.

 Selection tests Practical tests are common when recruiting for a position where an easily tested skill is required, such as certain secretarial skills or the ability to speak a foreign language. If a test is to be used as part of the selection process it is usual to advise candidates of this in advance. Psychological tests are used to assess aspects of a candidate such as motivation, personality type and attitudes. Such tests have been prepared by psychologists and are available commercially for use by companies in their selection process. The results of such tests must be treated with caution and those involved in the application of the tests and in the interpretation of the results should be fully trained.  References It is usual to take up a person's references once primary selection has been made as a way of confirming choice or doing a final check on a candidate. References can be helpful but again they must be treated with caution. There is usually an unknown factor with references because you do not know the precise relationship between referee and candidate. A reference may be: (a) Biased in favour of the candidate due to a personal friendship (b) Biased against the candidate due to a personal dislike (c) Biased in favour of the candidate because the referee wants to get rid of them! (d) Biased against the candidate because the referee wants to keep them! (e) Impartial and accurate You may get a more informative reference if you telephone the referee; in this way you may be able to form a better impression of the referee's true opinion of the candidate. It is important not to take up a reference without the applicant's consent.  Interviews Interviews are still the principal method of selection. The most widely quoted definition of interviewing is a very simple one which states that "an interview is a conversation with a purpose". The purpose is normally to exchange information and the term "exchange" implies that the flow of information is a two-way one – it provides an opportunity to collect information from the candidate as to his/her suitability for the job as well as to give information to him/her about it. There are basically two forms of interview: (a) Panel interviews – This involves a team of interviewers meeting the candidate together. It is less time-consuming and more administratively convenient than the alternative explained below. The experience is intimidating for candidates, however, and it is difficult to pursue in-depth questioning. (b) One-to-one interviews – Candidates are interviewed by a single interviewer, or undergo a series of different one-to-one interviews with each member of the interviewing team (sequential interviewing). This approach is more likely to allow thorough and rigorous questioning, and should encourage candidates to relax and talk freely. It can, however, prove awkward to timetable such arrangements if several interviewers are involved. Interview time should be spent discussing those matters which are relevant to the application. This will normally mean concentrating on the following points: (a) Evidence of the applicant's ability to do the job as defined by the job description and the person specification, usually building on information supplied during the application process.

(b) Evidence of the applicant's motivation in applying for the job, which is one issue that can only be assessed by interview questioning. (c) Provision of information about the organisation, the job and the terms and conditions of employment on which the applicant might be engaged. It is very important to avoid personal bias and assumptions about the candidates during interviews. In particular, in discussing personal details, care should be taken to avoid infringing the provisions of the Sex Discrimination Act. Once the selection procedure has been completed, it is time to make a choice between the candidates who have shown that they are suitable for the vacant job. This should be immediately after the selection procedure, but in some circumstances, there may be a delay whilst all candidates are considered. The successful candidate will be made an offer of the job, usually based on the information set out in the job description, although for some jobs there may be some negotiation about terms and conditions. The offer may also include qualifying conditions such as subject to references, health check, etc. It is good practice to notify those who have been unsuccessful as soon as you can, but it may be wise to wait until the selected candidate has accepted the position before notifying everyone. If there are two or three candidates whom you would be happy to employ in the position offer the job to your first choice candidate, but don't reject the others until the first choice has officially accepted. This way, if the first choice does not accept the position for whatever reason, you have another candidate lined up. It is important to tell these candidates that you were impressed by them and that the decision was close, but you considered them less suitable for that particular job, and not in wider terms; you may find that you need them in the future (or if the chosen candidate lets you down at the last minute). If internal applicants have been interviewed, but rejected, it is good practice to discuss with them why they did not get the job. It may be possible to advise them about any areas where they could develop their skills in order to build up their experience and increase their chances of success when any future vacancies arise.

Employee Induction Selecting the right candidate for the job is just the beginning; now it is time to convert the successful applicant into a reliable and productive member of staff. We have already noted the high cost in terms of both money and time that recruitment incurs. It is therefore obvious that it is better to retain good employees than to be called upon to replace them regularly. The induction of a new employee into the organisation is the beginning of the process that may turn him or her into a long-term, loyal member of staff. Poor induction demotivates people and demotivated staff will lead to high staff turnover. It may be said that the induction process begins even before the candidate is offered the job. The impressions formed at interview or on other visits to the organisation's premises will remain with the successful candidate once they begin work. The attitude of company staff that the candidate has met and the style of correspondence or telephone communications involved in the process of inviting the candidate to interview and making the job offer will have given the new employee expectations of how he/she will be treated. Written documentation will demonstrate the standards that the organisation finds acceptable so, for example, a spelling mistake in a letter inviting a candidate to attend an interview will have created a poor impression even before they have come to the premises. It is therefore important that everyone involved in the recruitment and selection process, even if only indirectly, is aware that they are out to impress. The purpose of induction is to enable the new employee to understand and work effectively in both the organisation and the job itself.

A lot of information about both can be provided in written form along with the formal offer of employment, in documents such as:  Statement of particulars of employment which must be provided to new employees – this is a statutory requirement  Employee handbooks, which some companies provide  Safety policy statements (another statutory requirement)  Pension scheme booklets  Job description Once a new employee starts, there is likely to be a period of induction training during which time he/she would not be expected to be fully effective in the job. The length of this period will depend on the requirements of the job itself, the employee's existing knowledge, skills and experience, and the complexity of the organisation. Apart from the details of the job, other general points covered in an induction programme will include:  Introduction to other employees.  Physical layout of the workplace.  Essential procedures, such as for claiming expenses, payment of wages, etc.  Important safety provisions, such as fire evacuation procedures.  General information about the organisation – history and development, trading policies, company projects, responsibilities of each department, HR policies and procedures, etc.

D. TRAINING AND DEVELOPMENT

Although training and development are primarily the concern of the HR department, all managers should be concerned with drawing out the full potentialities of their subordinates and staff.

The Organisational Context We have already noted the role of training and development in respect of HR planning. It stems from a number of influencing factors, including:  The need to respond to changes in the external business environment of the company, including changes in legislation, both UK and EU; changes in economic policy, such as interest rates; new advances in technology and technological processes, etc.  The need to respond to changes in the internal environment of the company, such as suppliers, customers, new systems, etc.  The need to respond to changes in the internal labour market: availability of employees with the necessary qualifications, skills and experience to cope with changes. Some organisations recognise the value of, and are proactive about, training and development activities. Others continue to operate in a state of complacency by failing to recognise the importance of, or invest appropriately in, training and development. We can consider the benefits of training and development by looking at some of the commonly held assumptions about it.

 Only well-off organisations can afford training Any organisation, large or small, has a wealth of learning and training opportunities at its fingertips. Employers do not have to spend thousands of pounds on a training programme. Valuable learning and training experiences can be gained from observing others (job shadowing or sitting by Nellie – watching what a trained person does on a day-to-day basis) and mentoring or coaching, etc.  Education, training and development are the responsibility of the human resources department It is true that training and development have to be someone's responsibility – and it appears natural and logical that it should be the responsibility of the human resource department, as training and development forms part of human resource strategy and the human resource plan. However, laying the responsibility for training and development at human resources' door should not be an excuse to ignore the whole organisation's responsibility to ensure that training and development is carried out. (a) Top management has a responsibility to ensure that it allocates sufficient money to support and finance development activity and that it forms part of the overall corporate strategy. (b) Line managers have a responsibility to ensure that they encourage their staff to develop themselves and that time is allocated for training and development activities. (c) Employees have a responsibility to ensure that they develop their knowledge, skills and experience and that training and development activities are mentioned in their formal appraisals. (d) Finally, the human resources department is responsible for ensuring that all training and development activities in the organisation are identified, planned for, implemented and evaluated in a cost effective way, with the organisation's needs in mind and in line with the organisation's objectives and strategy.  Any training is relevant In some ways any training is good – but it must be appropriate for the individual, the organisation and for the strategic direction of the company. Much money has been wasted over the years by companies who feel that they must train staff – but do so without any specific planning or focus. As such, training becomes just another chore and line managers and employees do not take it seriously. It is therefore vital that all training carried out is relevant and necessary and not merely training for training's sake!

What Is Training and Development? The essential difference is that:  Training is work-oriented – organisations train their employees so that they can perform their work tasks effectively.  Development is individual-oriented – it is more than just training. A person may be developed in the course of training. The main purpose of development, however, is to lead the individual to realise and use more of his/her potential capacity – and to increase that potential to open new horizons. It is related in each case to a particular individual. It depends on his/her particular needs and what they might become. It can never be mass-produced as training may be, but must always be tailor-made. It may be a prerequisite of promotion to (or selection for) higher-grade work, but it is not primarily and solely work-oriented.

When managers undertake staff development, they are really helping people to help themselves. Individuals will have different needs at various times in their work lives, so these will require different treatments. There are a number of different types of development processes at work within an organisation.  Organisational development (OD) Organisational development is the name of a particular approach to management which is based on continuously asking the question: "What changes do we need in our organisation and the way it is being run in order to help it achieve its objectives?" OD is based on the concept that an organisation develops and changes – in its structures, jobs and the deployment of staff – through the development of its staff, both in terms of their work abilities and as whole people. Only in that way will the organisation be able to implement change and improve efficiency and effectiveness.  Staff development This refers to the way in which opportunities are offered to employees to follow a range of programmes aimed at developing their knowledge, skills and experience in the job and in the wider context of the organisation. It has considerable benefits to both the organisation and individual employees in preparing candidates for promotion, and may be part of a planned programme related to succession planning. A number of techniques can assist staff development – for example, job rotation allows staff wider experience and the ability to see their work in the context of the whole organisation.  Career development Career development is an important aspect of personal development in organisations. It is individual-led as opposed to organisation-led and involves employees formulating their own personal development plans (PDPs) which outline objectives and timescales for career development activities. It includes developing elements of employability – knowledge, competencies and skills that enhance an employee's employment portfolio. It also encompasses desirable experience that can be transferred to another job. This very much places the emphasis on the individual organising his/her own development activities. It is also a way of improving employee motivation and morale. Many professional institutes, such as the Chartered Institute of Personnel and Development or the accountancy bodies, require their members to undertake continuous professional development (CPD) in order to keep their knowledge, skills and experience up to date. Action plans/development plans should be reviewed on a regular basis to see if objectives have been achieved.  Management development (MD) MD aims to help individual managers achieve their full potential – to "grow with the job", both in work abilities and as people – in order to strengthen the organisation's overall management. Part of the MD approach is to encourage managers to go on various training schemes or short courses, and then to put the skills they acquire to good use in their jobs. Like OD, MD is based on continuously asking a question; this time the question is: "How can we improve the management of our organisation?"

Modern organisations do not see MD as a passive situation where organisations develop their managers. Rather, managers themselves identify their development needs and spot the new skills they need to develop and further their careers. The organisation needs to facilitate this by making the appropriate resources available and encouraging the process. Some may create trainee management positions or assistant manager roles to encourage MD.

Training Methods Training methods encompass the ways in which information, knowledge, skills, etc. can be passed on to a target audience. The methods used will take into account the time and budget available and the complexity of the information that must be passed on to participants. Whilst the subject of individual training activities will invariably be job related, the methods also form the building blocks of development programmes. There is a basic distinction between on-the-job and off-the-job training.  On-the-job training On-the-job training can be one of the cheapest yet most effective methods of training. It enables knowledge and skills to be passed on in a realistic working environment and provides the opportunity for trainees to learn from established experts who are familiar with work processes and the intricacies of using a piece of machinery, its component parts, etc. On-the-job methods include: (a) Job rotation – trainees gain experience by doing a range of different jobs. (b) Attachments or secondments – trainees spend periods of time in various departments, often as an assistant to a more senior member of staff, in order to gain knowledge and experience of the organisation and its activities from a different perspective. (c) Action learning – trainees learn a new job by doing it under the supervision of an experienced person. (d) Job shadowing (often called sitting by Nellie) – trainees learn the job by watching or working with an experienced post-holder. There is a possible difficulty here, though, in that bad habits can easily be passed on to an "impressionable" trainee. Also included under on-the-job methods are coaching and mentoring. These are becoming increasingly popular. The trainee is placed under the guidance of an experienced manager who provides instruction, advice and counselling on how work processes and tasks should be carried out. Coaching and mentoring help trainees to set and achieve targets, identify learning opportunities and build on experience, identify strengths and weaknesses and, finally, exchange feedback on performance.  Off-the-job training This encompasses both of the following: (a) Formal external education and training courses run at universities and colleges on a day release, evening or full-time basis, as well as distance, open and flexible learning courses; these usually lead to some form of qualification or certified recognition of achievement; (b) Specific skills training or development activities which take place away from the normal workplace and are often provided by specialist training agencies. These

may be tailored to the particular needs of the organisation or be of general application.

Competency-Based Training The main role of training is to fill the gap between existing knowledge and skill and the desired level of knowledge and skill. This can be approached in many ways, with the usual starting point a training needs analysis. One initiative which has been developed to tackle training gaps is competency training. The organisation identifies key competencies for each level of the organisation and develops training programmes to meet these requirements. The process works as follows:  Identify core competencies at each level of the organisation in terms of knowledge and skill requirements. There can be core elements applicable to all staff at a single level, or particular requirements for specific jobs.  Develop a training programme to develop and assess those competencies. The development process can involve block-release courses, manuals, distance-learning workbooks and technology-based solutions. In some cases the process also involves interaction with colleagues and customers.  At each stage of the training process, the trainee is assessed by internal or external verifiers or both. The assessment process can be diverse, using examinations and tests to assess underpinning knowledge and performance assessment in customer interviews or simulated role-plays.  The competency programme may include an element of formal recognition by the award of internal or external certificates to confirm competency. Some considerable work has been done on the National Vocational Qualification (Scottish Vocational Qualification in Scotland) programme, a government-led initiative to promote competencies. These are industry- or sector-specific attempts to increase the general level of competency training, and NVQs are awarded at various levels – for example, in the area of management, level 2 refers to supervisors, level 3 to junior management, level 4 to middle management and level 5 to professional senior managers. Many large institutions build NVQ programmes to meet their own specific needs rather than applying industry standards.

Professional Education Education facilities for those in employment are extremely diverse in the UK. The worker is sometimes spoilt for choice, with qualifications ranging from GCSEs through to higher degrees. The purpose of education should not be confused with that of training. Education does not necessarily make the person better at the job, though it should (theoretically) enable them to become more adaptable and ready to learn. The purpose of education is to broaden the person and provide a wider perspective on business issues. The professional bodies are worthy of note here in that they offer broad-based programmes designed to develop students' knowledge and skills in particular occupational areas, such as accountancy or HRM. There are usually a series of levels of qualification through which the student may progress, culminating in the achievement of the professional standards of the body. In many occupational areas, possession of the appropriate professional qualification is almost essential to developing a career in that area.

E. MOTIVATION

Motivation is an important facet of the management of human resources in the workplace. It is linked with individual satisfaction, performance and commitment to organisational goals. It can often mean the difference between good performance and poor performance. Various definitions of motivation have been proposed, but one of the simplest, and possibly the best, is given by the International Dictionary of Management (1990): "Motivation is … process or factors that cause people to act or behave in a certain way." These factors can have a profound effect on an individual's behaviour at work and can mean the difference between poor job satisfaction, low morale and demotivation.

Theories of Motivation There have been and are many schools of thought surrounding motivation at work. Some of the main ones are: (a) Frederick Taylor In his book The Principles of Scientific Management (1911), Frederick Taylor stated that it was money that motivated individuals to work harder. He studied how employees worked in a steel works moving pig iron. By analysing and recording each action, Taylor was able to devise more efficient ways of working and increased the amount moved from 12,5 tons per day to 47 tons. He viewed workers as mere economic agents, to be directed and supervised by managers. Workers would respond to a wage system that would reward effort such as "piece rates". Taylor's critics said that he took no account of the human side of work – the need for interesting and challenging work as well as the need for responsibility and recognition. (b) Elton Mayo Mayo believed workers were motivated by non-financial factors. During experiments at Western Electric's Hawthorne plant in Chicago in the 1920s, he realised that productivity increased when the workers were consulted and respected. The regular contact and discussions raised the workers' self-esteem, and labour turnover fell dramatically while productivity rose. Following this study, the issue of involving workers in discussing tasks was known as the Hawthorne Effect. (c) Abraham Maslow's hierarchy of needs Maslow's research, conducted in 1954, found that individuals have five levels of need, as shown in Figure 9.2. The needs are arranged in a hierarchy, and an individual will continually seek to satisfy a higher level of need once a particular level has been achieved.

Self- actualisation

Esteem needs

Social & belonging needs

Safety & security needs

Physiological needs

Figure 9.2: Maslow's Hierarchy of Needs

Self-actualisation is the pinnacle of the pyramid, and it is a state that only a few individuals achieve. It has been described as "a state of mental, physical and emotional happiness" that is attained when individuals achieve a particular goal or target and are "at peace" with themselves. However, if a state of self-actualisation is achieved, it tends not to be permanent. Note that demotivating factors that occur, in either the individual's personal or working life, often have the effect of forcing the individual back down the hierarchy. Maslow's model provides an indication of how individuals can climb the hierarchy if their levels of motivation are satisfied by a variety of organisational factors. This is shown in Figure 9.3.

General rewards Factors offered by Needs sought organisation

Physiological Food Good working conditions Water Good pay Air Canteen facilities/cafeteria Sleep Sex

Safety & Security Safety Safe working environment Security Job security Protection Incentives and benefits Stability

Social & Sense of Good leadership Belonging belonging Love Cohesive and co-operative work groups Affection

Esteem Self-respect Job title Self-esteem Authority and power Recognition High status Status

Self-Actualisation Achievement Advancement in company Advancement Challenging and rewarding job Growth and Job achievement creativity

Figure 9.3: Hierarchy of Needs – How Needs Are Sought and Satisfied

(d) Herzberg's two-factor theory The two-factor theory divides the factors at work into: (i) satisfiers or motivating factors – those factors which, when present to a marked degree, increase satisfaction from work and provide motivation towards superior effort and performance; and (ii) dissatisfiers or hygiene factors – those factors which, to the degree that they are absent, increase worker dissatisfaction with jobs. When present, they serve to prevent job dissatisfaction, but do not result in positive satisfaction and motivation. Satisfiers are related to the job and dissatisfiers are related to the working environment and conditions, as shown in Figure 9.4.

Satisfiers Dissatisfiers (motivating factors) (hygiene factors)

Recognition Working conditions and environment The job itself and responsibilities Salary/wages Satisfaction, advancement and a Working relationships sense of achievement Benefits and incentives Prospects for promotion Leadership displayed by managers

Figure 9.4: Herzberg's Motivating and Hygiene Factors

There is a strong similarity between Maslow's hierarchy of needs and Herzberg's two- factor theory. Maslow's first three needs (physiological, safety and security, and social and belonging) resemble Herzberg's hygiene factors, and Maslow's final two needs (esteem and self-actualisation) resemble the motivating factors.

Motivational Factors at Work In the light of the above discussion of the theories of motivation, we can identify a number of factors that affect motivation at work. These include the following.  Intrinsic goals and motivation These can be described as internal goals (within us) that drive us on to achieve personal goals and targets. They are often psychological and emotional goals (such as the goal to achieve praise for a job well done).  Extrinsic goals and motivation These can be described as goals and targets that are outside the control of the individual. Extrinsic motivation includes rewards that are offered for tasks that are implemented well or to target, or the rewards that will be offered (such as promotion) if the individual completes a particular training or educational course.  Remuneration and rewards These include the payments that individuals receive either on a weekly or monthly basis, incentives that can be offered (monetary and non-monetary), and career and promotion prospects (a job with little or no promotion prospects may not stimulate as much motivation as a job that has excellent prospects).  The working environment This includes the actual job – its design and how interesting it is; the need to belong to a group, and the special contact individuals have with group members. It also encompasses the organisational culture, its beliefs, norms and values, etc.  The individual's needs and drives These include physical power (the drive to satisfy physical appetites, e.g. food), psychological needs (the need for praise and achievement) and economic needs (the need to work to be able to maintain one's standard of living).  Personality traits/characteristics These include whether an individual is personality type A (highly strung, emotional, prone to stress, competitive) or personality type B (laid-back, "happy-go-lucky", finds it easy to relax and unwind, etc.) and whether the individual is an introvert (rather shy and withdrawn) or an extrovert (having an outgoing personality).

 An individual's intelligence and abilities These include innate abilities (within the individual), skills that have been acquired through experience and training, and the ability of the individual to think critically.  An individual's personal wants and values These include peer group influences, physiological and psychological needs, pleasure, socialisation, etc. All these factors illustrate that motivation at work is more complex than simply providing satisfaction of an individual's wants and needs. Managers are expected to enhance the working experience for their employees. Managers also have to be prepared to recognise employees within their teams as individuals – each with their own personality, personal goals, abilities, skills and expectations.

Job Satisfaction Job satisfaction refers to the satisfaction derived by an employee through the performance of his/her job. It is a key element in any list of motivational factors and seeking to improve job satisfaction is an important challenge for any organisation. The actual design and content of jobs can mean the difference between motivated, satisfied and challenged employees, and dissatisfied, bored and unchallenged ones. The factors which are thought to cause dissatisfaction include monotony, repetition, lack of control and stress. Thus, an attempt should be made to design these factors out of jobs wherever possible. There are several methods that managers can use to achieve this – job enrichment, job enlargement, job rotation, empowerment and team working.  Job enrichment Job enrichment seeks to develop the job by offering more responsibility, diversity and breadth to the post-holder. It is also referred to as vertical extension, indicating that it involves assuming tasks and duties which are above those of the current job, thus offering the employee a greater challenge and the opportunity to develop his/her abilities. Job enrichment activities may include giving the opportunity: (a) To work in teams (projects and assignments) (b) For employees to become accountable for the roles they perform (c) To remove some of the constraints and controls that can restrict employees from developing in, and enjoying, their jobs  Job enlargement Job enlargement is a method by which the range of tasks contained within the job are enlarged or increased. It is also known as horizontal extension. Job enlargement gives employees greater variety and presents them with a job that becomes bigger in its content and structure. In jobs that are perceived as routine and monotonous, it can be a way of providing an increase in the tasks that the individual performs, as a means of reducing the monotony. However, some employees may see job enlargement not as a means of improving their motivation or job satisfaction, but as a method of increasing the number of monotonous and boring tasks they undertake. Certain employees may feel happier in a role where they do not have to concentrate too hard and think about the job in too much detail. The job may be routine and monotonous, but they can interact with workmates or listen to music while they work without it affecting their level of output and performance.

 Job rotation Job rotation basically speaks for itself – it involves the employee being moved within the organisation to undertake a variety of different tasks. It enables the individual to appreciate how his/her job fits in with other corporate functions within the organisation and how other jobs interrelate to help the organisation remain successful. The job can be rotated for any given period of time, be it months or years. It offers learning and development opportunities to individuals insofar as new skills are developed as well as existing skills being passed on to others. Again, job rotation is not a panacea for all ills, but it does provide a means of relieving some of the monotony and boredom that inevitably manifest themselves in employees in many organisations.  Empowerment and team working The work of Rosabeth Moss Kanter stressed the need to delegate authority to individual workers rather than the senior managers holding on to the decision-making process. By cascading authority down the line, more of the workforce is actively involved in decision-making, thus creating a sense of ownership. In the same way, responsibility can be devolved to teams as well as to individuals. In team working, production is broken down into large units with teams given the responsibility not only to complete the task, but also to decide how the task is done and by whom. This method has been successfully applied in Honda's factory in Swindon and in the John Lewis retail chain.

F. REMUNERATION

All organisations need some form of payment policy or strategy which will enable it to recruit, motivate and retain the staff it needs. A payment policy or strategy will set out the way in which employees' pay is determined. There are, essentially, two aspects to this:  basic pay, which is invariably based on some form of pay structure within which each job is allocated to a certain pay level; and  performance-related pay, whereby individuals may increase their basic pay by receiving additional payments for particular levels of performance in the job. The first aspect relates, therefore, to the value given to the job, and the second relates to the value given to performance. The balance between the two aspects and the values attached are determined by a number of factors as we shall consider below.

Influences on Payment Policy There are many different factors that influence the structure of the payment system and the level of pay or remuneration in organisations. These include:  Market rates Most organisations operate in several different labour markets. These include the local labour market for more junior employees, the national market for managerial, professional and highly technical staff and, possibly, the international market for some jobs. An organisation needs to be clear about where its pay rates and fringe benefit packages are located in comparison with those of other organisations.

Some organisations base their complete pay structure on the market position, i.e. "the going rate". Others may just apply market rate salaries to particular jobs with recruitment or retention problems.  Equity Equity may be defined as the way in which payment policy is seen to be just and fair because pay matches individual contribution, ability and the level of work carried out; pay differentials are related to clear differences in the degree of responsibility; and equal pay is received for equal work. Whilst complete equity is impossible, a payment policy should strive to achieve a reasonable level of equity by adopting a systematic approach to establishing the value of jobs. Some organisations use a formal system of job evaluation to determine grades and wage/salary ranges, and the allocation of jobs to grades. Whatever process is used, though, it should be well defined and consistent, particularly with regard to performance-related systems, as they can demotivate if they are perceived to be unfair. It is also essential that attention is given to paying the same for work of equal value, to ensure equal opportunities legislation is taken into account. However, practice is usually a compromise between internal equity and external market pressures. Hence, some occupational groups may be given special treatment where market rates are high and the job is critical to the performance of the organisation.  Employee satisfaction For a payment system to be an effective motivator (or at least for it to minimise dissatisfaction), it must command the support of the workforce. The level of satisfaction is likely to be related to the following aspects of its equity:  fairness – the extent to which the system is considered fair, in that rewards reflect ability, contribution and effort;  expectations and value – the extent to which rewards meet employee expectations, and the value of the reward is commensurate with the effort and skill needed to obtain it;  internal comparisons – the extent to which pay is comparable between employees doing similar jobs at a similar level of competence;  external comparisons – the extent to which pay is comparable to, or better within the organisation than, elsewhere;  self-evaluation – the extent to which rewards are in line with what employees feel they are worth;  total remuneration package – the effect of the total package rather than any single element.  Organisational culture Payment policies should reflect corporate culture, although they can also be used to stimulate changes in that culture. Policies must also be relevant to the situation in which the organisation currently operates and its future direction. This means that payment policies should be integrated with the strategic aims of the organisation. Payment policies will vary according to the type of organisation. For example, a large bureaucratic organisation may prefer a graded salary structure and highly formalised salary administration. A smaller and more informal organisation, particularly one which is growing and changing rapidly, may prefer to keep its policies and procedures flexible in order to respond quickly to change.

 National minimum wage The introduction of a minimum wage fixes the lowest rates which can be paid to employees. It may also affect other rates as well through the need to retain pay differentials between different types of job.

The Total Remuneration Package As noted above, quite often it is the effect of the total remuneration package, rather than any single element, which secures employee satisfaction. The total package will comprise a balance between financial and non-financial rewards, with the non-pay elements often being consistent across the whole of the organisation, rather than being associated with particular payment levels. Figure 9.5 summarises the non-pay elements of the total remuneration package.

Financial benefits Non-financial benefits

Sickness pay Leave entitlement Superannuation scheme Compassionate leave Season ticket loan Flexible working hours Removal expenses Additional maternity/paternity leave Travel expenses and/or car allowances Career breaks Provision, or assistance with Creche purchase, of a car Education facilities and study Subsidised meals leave Clothing allowances Sports and social club facilities Private medical insurance Loans for other purposes

Figure 9.5: Non-Pay Elements of the Total Remuneration Package

Payment Structures Pay structures are an organisation's salary and wages levels or scales applied to single jobs or groups of jobs. They determine the basic pay of employees in particular jobs, although they may have elements of performance-related pay built into them. There is no clear differentiation between the terms "salary" and "wages". However, it is invariably the case that salaries are expressed as an annual rate for the job and are usually paid monthly, whereas wages often expressed as a weekly or even an hourly rate for the job and are generally paid weekly. Where an hourly rate is used, there will be some form of timing system used to keep track of the hours worked. There are four main types of pay structure:

 Graded salary structures This system comprises a pre-determined series of grades, each covering a given salary range from a minimum to a maximum pay level. Jobs are then evaluated and allocated to a particular grade within the structure. The salary range encompassed by the grade is divided into a series of increments, progression through which is determined by performance and/or time. Performance- related progression may be by several increments at a time, whereas time progression is invariably by one increment annually.  Pay spines These systems are used mainly in the public sector and are similar in principle to graded salary structures. The pay spine system is based on a continuous incremental scale extending from the lowest to the highest paid jobs covered by the system. This incremental scale is the "spinal column" and each point on the scale represents a "spinal point". The pay levels attached to the spinal column are usually determined annually by national negotiation and agreement between unions and employer organisations. Jobs are graded by reference to a range of spinal points. This allows some flexibility between different employers using the same spine in defining the salary range for particular classes of jobs. As with graded salary structures, workers may progress through the salary range on the basis of time and/or performance. Increments may be withheld, or accelerated increments awarded on the basis of performance, and some organisations add points on the top of the normal scale to enable staff at the maximum of their grade to continue to gain merit rewards.  Individual job range/pay point In situations where jobs differ widely, or where flexibility and quick response to organisational change or market rate pressures are essential, individual job range systems may be desirable. Such systems define a salary bracket for each individual job, with the mid-point of the range being related to market prices. In certain situations, particularly where there is a significant element of performance- related pay available on top of basic pay, or in fixed-term contract jobs of up to three years' duration, it is quite common for the individual rate of pay to be fixed at one point, rather than covering a range. This is the case with many manual jobs where employees are paid by "piecework" (see later).  Rate for age scales These are basically incremental scales in which a specific rate of pay or a defined pay bracket is linked to age. Such scales were used for young employees under training or other junior staff carrying out routine work, but they are now found far less frequently and tend to be limited mainly to school leavers and trainees, up to the age of 18 years.

Performance-Related Pay Performance-related pay (PRP) has always been a feature of pay for many manual workers, but in recent years it has become a major element of the remuneration package across all types of employee. The essence of PRP is to relate financial rewards to individual, group or corporate performance in respect of specified targets. The overall aims are to improve the performance of the organisation, groups of employees and individual employees, by:

 motivating all employees, not just the high fliers (who may not need motivating through this method anyway, although it is necessary to avoid demotivating them by under- rewarding achievements);  increasing the commitment of employees to the organisation by encouraging them to identify with its mission, values, strategies and objectives;  reinforcing existing culture and values where these foster high levels of performance, innovation and team work;  helping to change the culture where it needs to become more results and performance orientated, or where the adoption of new values should be rewarded;  discriminating consistently and fairly on the distribution of rewards to employees according to their contribution;  reinforcing a clear message about the performance expectations of the organisation, for example by focusing on key performance issues;  directing attention and effort where the organisation wants them by specifying performance goals and standards;  emphasising individual performance or team work as appropriate;  adjusting pay costs to take account of the organisation's performance. There are two main types of performance-related pay: (a) merit pay, based on the employer's assessment of an individual's performance during the previous period; and (b) incentives and bonuses, where the employee (or group of employees) is told in advance the relationship between measurable levels of performance and pay levels.  Individual merit pay Merit pay is becoming increasingly common in the previously rigid pay structures where progression through the incremental steps of salary ranges has traditionally been based on length of service in the particular grade. It is linked closely with the concept of appraisal. Basically, individual merit pay comprises the award of incremental pay increases within the salary range for the grade based on an assessment of the employee's performance. Many organisations now allow a considerable degree of discretion to departmental managers to determine the extent of such merit increases which, in turn, allows management flexibility to devise differential schemes linked to levels of performance. Such schemes provide for individual salary progression rates, based directly on performance, and emphasise increasing competence gained through experience rather than simply time served. However, there are a number of problems and disadvantages associated with merit pay schemes. (a) They are dependent on the quality of appraisal which can be arbitrary, subjective or inconsistent, especially when the appraisers have not been adequately trained. (b) Unless they are carefully designed and managed they can demotivate some employees who may be providing a reasonable if not exceptional contribution. (c) Merit payments, as distinct from bonuses, create extra payroll costs when benefits such as pensions are related to base pay. (d) Merit payments are effectively permanent increases in salary, yet the quality of performance in future years may not justify this payment.

(e) They are only effective as a motivator if rewards are clearly related to performance and are of a significant value. (f) They may not deal with the problem of highly rated staff who have reached the top of their scale and for whom there are no immediate prospects of promotion (consideration may need to be given to bonus payments in these circumstances).  Incentive and bonus schemes These schemes seek to provide a basis for rewarding performance outside of the basic pay structure for performance related to the achievement of defined objectives, targets and standards. Incentives and bonuses are similar in that they are both lump sum payments related in some defined way to performance, but we can distinguish between them as follows. (a) Incentives are payments linked to the achievement of previously set and agreed targets. They aim to encourage better performance and then reward it, usually in fixed proportion to the extent to which the target has been reached. Incentive schemes are found from shop floor to boardroom and can be applied to individuals or groups. They vary principally in the type and range of targets applied. (b) Bonuses are essentially rewards for success and are paid either at the time the individual or group achieves something outstanding, or at a given point in the year. By their very nature, bonuses tend to be discretionary. The amount paid out depends upon the recommendations or decisions of the employee's boss, the Chief Executive or the board, and is constrained only by budgetary limits. Bonus schemes are therefore often less structured than incentive schemes. There are a number of established incentive schemes. (i) Profit sharing Profit sharing has been used successfully by companies for many years. It basically speaks for itself insofar as employers share a proportion of the profits with employees. The level of reward that is allocated to employees usually depends on their length of service and where they are on the salary band/incremental scale. Most schemes apply only to senior management – those whose decisions are related directly to the overall performance of the organisation. Not all the profits shared are monetary. Companies may decide to allocate shares to employees, these shares then yielding a dividend and also hopefully increasing employee commitment to the achievement of organisational goals because they have a stake in the business. When making profit-share payments by way of shares, employers should remember that the value of shares can go up and down. If they go down, employee commitment may wane, so it is sensible that other types of bonuses are used as a supplement (not necessarily monetary). (ii) Payment by results – groups The group can work towards an agreed target and then distribute it equally between them. This saves the employer monitoring the performance of individual workers. The main drawback of occurs when some group members complain that their peers are not putting in the same performance and commitment but are receiving the same rewards.

(iii) Payment by results – individuals Here, the most common schemes are those applied to manual workers where individual payments on top of basic pay (which may be quite low) are dictated by "piecework" – payment according to the number of units produced. This has long been regarded as the prime motivational tool because the more the employee produces, the higher his/her earning capacity. However, it may also be a demotivator insofar as morale can drop if for any reason the standards of production necessary for what is seen as an appropriate level of reward cannot be achieved. Another, very different, example of this type of system can be seen in respect of salespeople who earn commission related to the volume or value of their sales. Finally, there are a number of advantages in using incentive or bonus schemes as opposed to merit pay:  rewards are sometimes immediately payable for work done well;  bonuses can be linked to specific achievements of future targets and this constitutes both a reward and an incentive;  payment is not continued as part of base salary irrespective of future performance;  lump sum payments are very appealing, as opposed to receiving a small amount each month as part of salary;  additional rewards can be given to people at the top of their salary scale without damaging the integrity of the salary structure.